Home-Sale Loophole Is Closed

The Internal Revenue Service has closed a potentially lucrative loophole that could have allowed wealthy homeowners to double the tax breaks available on the sale of their homes.

The agency ruled Tuesday that homeowners can’t combine two tax breaks that would have doubled the amount of profit from a home sale that could be sheltered from taxes. The maneuver could have allowed as much as $500,000 per person--or $1 million per couple--in profit to be exempt from tax.

The loophole was an unintended consequence of a new capital gains law that went into effect in January. That law cut capital gains rates on property held for long periods of time, although it also raised questions about how the law might be applied to the sale of a personal residence.

“Killjoys,” said Philip J. Holt-house, partner at the Los Angeles tax law and accounting firm of Holthouse Carlin & Van Trigt. “This was about the only fun you could get out of that new capital gains law, and they’re not going to allow it. I’m deeply disappointed.”

The new law shaved two percentage points off capital gains tax rates on assets held for five or more years. Profit on capital assets--stocks, bonds, real estate etc.--purchased after Dec. 31, 2000, and held for at least five years generally will be taxed at an 18% rate, rather than the ordinary 20% capital gains rate.

The law also allowed taxpayers to “restart the clock” with assets they owned before 2001. This process, which involved a so-called deemed sale, allowed a longtime holder of a stock, mutual fund or other asset to get the benefit of the lower tax rate going forward.

It works like this: Taxpayers who owned a capital asset could file a special form with their returns for the 2001 tax year that allowed them to treat the asset as having been sold and immediately reacquired on Jan. 1, 2001.

This phantom sale would trigger capital gains taxes on the difference between the market value on the date of the deemed sale versus the cost at purchase--the taxpayer’s paper profit. However, any future profit earned on that security would be taxed at the lower rate, assuming the taxpayer held the asset for five years following the deemed sale.

Because of the upfront cost--the cost of paying capital gains taxes on profit that would otherwise be deferred until the asset actually was sold--tax experts said few individuals would want to do a deemed sale of their stock holdings. (The law specifically prohibits deemed sales from being used to trigger capital losses.)

However, experts were intrigued by the idea of using a deemed sale with residential real estate for a simple reason: An existing provision allowed homeowners to exclude from tax as much as $250,000 per person, or $500,000 per couple, in profit on the sale of a personal residence that the homeowner has lived in for at least two of the last five years.

Taxpayer Can Still Do Deemed Sale

For wealthy taxpayers with multimillion-dollar homes, using the deemed sale in concert with the residential real estate exclusion presented the possibility of a windfall.

Theoretically, taxpayers could have used a deemed sale to lock in a current value for their homes, exclude the profit from tax, then restart the clock on the residential real estate exclusion, effectively allowing them to do it again two years later. That could save as much as $100,000 in capital gains taxes for those with homes worth $1 million more than their purchase prices.

The IRS has no idea how many taxpayers planned to use deemed sales in this manner--deemed sales would not be reported on tax returns until 2001 returns are filed in 2002.

However, agency officials said they’d received many requests for information about whether deemed sales were permissible with residential real estate.

The IRS ruled Tuesday that taxpayers can do a deemed sale with residential real estate, but they can’t use the residential real estate tax exclusion in concert with the deemed sale provision.

In other words, taxpayers who do a deemed sale of a personal residence must pay capital gains taxes on the profit. If they did a real sale of their residence, they would be able to exclude that profit from tax.

“The [deemed sale] election confers tax benefits on the electing taxpayers, but it imposes a tax cost as well,” the IRS said in the ruling. “Exclusion of the gain from the deemed sale would frustrate this balancing of benefits and burdens.”

The IRS said the intent of Congress was clearly not to create a doubling-up of the residential real estate exclusion by allowing deemed sales.

“What this tells you is that neither Congress nor the IRS thought about the interaction of these code sections when they passed this,” Holthouse said. “The good news is that the IRS gave this advice now, before anyone has done a deemed sale. If they issued this ruling after January, it could be a real kidney punch.”