Q: We purchased our house in the l970's for approximately $40,000, and have put in about $25,000 of improvements. We lived there until September of 1999, when we retired and moved to a retirement home. For the past two years, we have rented out the house, and have received a decent rental income. The house is now worth almost $700,000, and we understand that if we sell the house before September of this year, we will have to pay a lot of capital gains tax. Unfortunately, we do not believe that we can sell our house that quickly, especially since the tenant has several more months to go on the lease. Is there any way that we can avoid paying the capital gains tax?

A: Let’s get some basic facts on the table first. Since you are married - and presumably filing a joint tax return -- if you have lived in the house for two out of the last five years before it is sold, you can exclude up to $500,000 of any profit you have made. (If you file a single tax return, the exclusion is limited to $250,000.)

Since you moved out in September of 1999, and lived there before that date, you must sell your house by September of 2002 in order to take advantage of this significant tax saving. Otherwise, your tax liability will be huge. Your basis for tax purposes is $65,000 (40,000 plus 25,000). If you sell the property for $700,000, excluding real estate commissions and closing costs, your gain will be $635,000. At the current 20 percent tax rate, you will have to pay Uncle Sam $127,000. And if you have taken any depreciation during the time the property was rented, you will have to pay an additional 25 percent on the amount that was depreciated.

On the other hand, if you can sell within the two-out-of-five year period ends, $500,000 of the gain will be excluded from t ax, and you will only have to pay tax on $135,000 of profit -- or $27,000. That’s still a lot of tax to pay, but clearly a lot less than if you cannot take the exclusion.

Thus, I would try to market the property immediately, even if you have to sell it for somewhat less than its market value. What you may lose by way of sale will more than be made up by the capital gains tax savings.

However, there is another approach which you may want to consider. However, a strong caveat is in order: this approach has not been approved nor authorized by the IRS.

Before l997, when Congress enacted the Tax Reform Act authorizing the up to $500,000 exclusion of gain, homeowners were subject to what was known as the “rollover”. Under this approach, if you sold your principal residence, and within either two years before or after the date of the sale you purchased another property, you were able to defer any gain which you made on the sale. The gain was deducted from the sales price of the new house, so that your tax basis was lowered.

Example: you purchased property for $40,000 and put in $25,000 worth of improvements. You sold the property for $300,000, and within two years had purchased another property worth at least $300,000. Although the new price was $300,000, since you had made a profit of $235,000 ($300,000 - 65,000), this profit was “rolled over” to the new house. Accordingly, the basis for tax purposes of the new $300,000 was still only $65,000. The tax theory for this was simple; you did not avoid tax, but only deferred it to a time when you ultimately sold your house. Then, assuming there were no other tax-saving devices available, you would have to pay all of the gain you made on all houses.

However, many people found that although they purchased a new house, they were unable to sell their old one within the two year period.

What did they do? They created a sub-chapter S corporation, and sold the property to their corporation for the full market price. This way, they deferred the tax on the sale, and when the subchapter S ultimately sold the property, its gain was relatively small.

A subchapter S corporation gets its name from the section of the Tax Code permitting such corporations. Over-simplified, this is a legal entity that is taxed much like a partnership, in that profits are taxed to the shareholders and not to the corporation.

In l983, an enterprising individual found himself in the situation where he had purchased a new house, but was not able to sell the old one within the two year period. Rather than despair -- and clearly rather than pay the capital gains tax on the profit he anticipated on the sale of his principle residence -- he decided to sell the house to a wholly-owned Subchapter S corporation that he had created.

The IRS was asked to give its opinion. In a private letter ruling dated September 13, l983, the IRS wrote the following:

...we conclude that section 1034 would govern the... sale of your home to Corporation provided that both the "old residence" and "new residence" qualify as your principal residences. No gain would be recog-nized to you provided the sale met all of the quali-fications of section 1034 of the Code.

However, if the new residence is later sold and gain recognized, that gain will be recognized as ordinary income to the extent of the gain that would have been ordinary income were it not deferred upon this sale under section 1034 of the Code. (Private Letter Ruling, 83-50084)

The IRS also stressed that under the facts of this case, the taxpayer had unsuccessfully attempted to sell his old residence before contemplating the sale of the Sub S Corporation.

It must be emphasized that this was a private IRS letter ruling, directed to a particular person. According to the IRS, such letter rulings may not be used or cited as precedence. However, the law was still the law, and the thought process of the IRS did give us some helpful guidance in those days.

It should also be pointed out that in l989, the IRS also issued a letter ruling on a similar topic, but this time stated that "no opinion is expressed as to whether the sale of Residence A to a corporation wholly-owned by Husband and Wife is a bona fide sale for purposes of section 1034 of the Code." (Letter Ruling 89-46021, August 18, l989.)

Clearly, there is no roll-over in existence today. However, it would appear that if you cannot sell your house now, you should consider selling it to a sub-chapter S, and if you are challenged by the IRS, you can make the same analogy to the roll-over concept. Incidentally, in the l980's, we used the sub-chapter S as the vehicle to test this concept. Nowadays, you might want to consider creating a limited liability company (LLC)-- wholly owned by the same owners as currently own your house -- and transfer the property to that LLC.

You will probably have to pay a recordation and transfer tax to the local government where your property is located. But again, this cost will be far less than the capital gains tax you may have to pay.

You also have to change your homeowner's insurance policy and put it in the name of the corporation or the LLC. If you have a mortgage, discuss the situation with your lender in advance of the transaction. You do not want your lender to call the loan, exercising the so-called "due on sale" clause. Most lenders will be understanding -- provided you let them know in advance of the sale.

Thus, one approach to defer payment of the capital gains tax is the sale of the old residence to a sub-S corporation or to a limited liability company. There are absolutely no guarantees that this technique will work, but it may be worth your exploring. You must, however, fully discuss this approach with your financial, tax and legal advisors before embarking on this route.

Published: July 15, 2002

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Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.