Watch out for ‘Deemed Sale’ Tax Loophole
This column targets a loophole that would let you sell your house for a gain of up to $1 million without paying any federal income taxes.
But don’t get too excited: The column is also about why you cannot do that, why people may think they can and why you should keep this confusion in mind during what promises to be a year filled with new tax legislation. In particular, small-business owners may want to think twice before they plan any home business & jobs strategies that would be affected by the way they’re thinking about taxes on a sale of residential property.
“Deem” a house sale, save $100,000?
First, some background. As many people know, you now can make a so-called “deemed” sale of an asset, in essence declaring a sale without actually selling the thing, and then paying taxes on any gains accrued up to the date of the deemed sale. Because assets that are purchased beginning this year qualify for an 18% capital gains rate if held for five years, this seemingly counter-intuitive option — pay taxes now rather than later — can make sense for someone who owns a stock that has appreciated very little to date but which has the prospect of much greater appreciation in the coming years.
This is a new law. Not so new is the very popular exclusion of up to $500,000 in gains on the sale of a home. Now, trace the logic of combining these two tax rules in the following three-step dance:
Someone with a home that has appreciated in value by several hundred thousand dollars (Hello, San Franciscans! Hello, Pacific Northwesterners! Hello, New Yorkers!) might “deem” the sale of the house, which is an asset just like a stock.
When you deem a sale, you have to pay tax on the gains. But since you’re deeming the sale of your house, why not also claim the exclusion of up to $500,000 in gains? That way, you don’t have to pay the capital gains tax you would otherwise have been obligated to pay.
In this scenario, you would then have a house with a new, higher basis — the amount of the “deemed” sale — without paying any taxes on the “sale.” Let’s say the house continues to appreciate for several more years. Eventually, when you really do sell the house, you again could exclude taxes on up to another $500,000 in gains. Pretty neat, huh?
It’s a slam-dunk! No, wait!
The Million-Dollar-Home-Gain-Exclusion got a real publicity pop when The Motley Fool Web site posted a story explaining how it all works. There was just one problem: The story was wrong. The strategy isn’t allowed.
I don’t want to pick on Roy Lewis, the Fool’s fine tax columnist. Even as I write this, he’s posted a notice that he got the story wrong and is working on a follow-up correction. It’s easy to see how even experts, let alone journalists, could get confused on this.
But I will pick on the IRS. In fact, I’ll let you in on a little secret: When I first asked the IRS directly about this tactic, they told me it was OK.
Even the IRS was confused
Oh, yeah. Even the IRS messes up sometimes. (Go ahead, insert your own joke here.) I asked the IRS about the potential million-dollar exclusion last December. The first answer I got from them was as follows: “Joseph, this is one of those ‘Sounds too good to be true, but it’s actually true.’ An individual can deem a sale on his residence in 2001, not pay on a gain . . . then two years later, sell a property at another gain up to $250,000 and again not pay tax. It can be done over and over again . . .”
Whoops! After some back-and-forthing, I eventually got the right answer — or at least, the answer the IRS is sticking to right now: Yes, taxpayers can deem a sale. But no, they cannot then avoid recognizing gains on the deemed sale. The key phrase, from the 1997 tax act that spawned all this, is in Sec. 311(e)(2)(A), which says that, “Any gain resulting from an election . . . shall be recognized notwithstanding any provision of the Internal Revenue Code . . .”
Translation: Sure, go ahead, deem the sale of your house. But get ready for a whopper of a tax bill if your property has appreciated.
Oh, and if your property has lost value since you bought it, you don’t get to take the loss on your tax returns. Double whammy.
We’ve got a wild ride ahead
Remember, the confusion in this case was over one tiny part of a tax bill that was passed a few years ago and that people have had lots of time to consider. Whatever you think of George W. Bush’s current tax drive (and I don’t think very highly of proposals like eliminating the estate tax, a levy that scares everyone but actually hits less than 2% of all taxpayers), the haste with which it is being pushed almost guarantees that there will be confusion and misunderstandings about some or even several provisions.
The moral of the story: Look before you leap at any new tax-saving “opportunities” later this year. Then look again. And again. Nobody can say for sure what a final tax bill this year will look like, but I can predict with a relatively high degree of certainty that it’ll stimulate business — for tax professionals.