Is there a "tax time bomb" ticking away for many American homeowners in their 50s and 60s? Could they end up owing the IRS money unexpectedly when they sell their homes, despite the availability of the seemingly generous $250,000 and $500,000 tax-free exclusion limits on home sale profits?

A prominent real estate tax attorney says the answer to both questions is yes -- particularly for people who've bought and profitably sold a series of homes dating back to the 1970s and 1980s.

Gerald J. Robinson of the New York law firm of Carb, Luria, Cook and Kufeld LLP, says that although Congress streamlined the federal tax rules covering home sales in 1997, owners who bought and sold prior to 1997 may be carrying large, unrecognized gains "rolled over" from previous sales that could come back to haunt them.

Robinson says the "tax time bomb" -- taxable gains in excess of the exclusion limits -- is not a problem solely for wealthy families with multi-million dollar homes. It also "can hit the upper middle income homeowner who has (owned) a home for many years in an upscale community or the upwardly mobile corporate executive who has deferred gains on home sales by a series of rollovers, while moving from place to place climbing the corporate ladder."

Many homeowners assume that the post-1997 tax-free exclusions will cover virtually all the profits they reap. But millions of current homeowners' tax-deferred gains reach back long before 1997. If they bought and sold their first homes in the 1970s or 1980s or before, for example, their accumulated taxable profits may shock them.

In his new book, J.K.Lasser's Homeowner's Tax Breaks, (Wiley, $16.95) Robinson sketches out the following illustration of the problem: A dual-income couple now in their 60s bought their first home for $45,000 in 1967. Their basis for tax purposes on that purchase was their actual cost -- $45,000.

They sold that house in 1972 for $100,000 -- a $55,000 gain. Using the then-standard "rollover" technique, the couple deferred taxation on that gain by purchasing a replacement home that cost more than the house they sold. The replacement home cost $105,000. The $5,000 difference in price was then added to the couple's adjusted basis, raising it to $50,000 ($45,000 original cost plus $5,000 on the new house).

In 1977, the couple sold the 1972 house for $195,000 and rolled over their gain into a $200,000 house. In a series of several subsequent sales and purchases through 1996, the couple rolled over -- deferred from tax recognition -- a cumulative $825,000 of gains as they moved from home to home, location to location. Pretty impressive.

In 1996 they bought a $950,000 house and currently are looking at selling it for $1.1 million. Also pretty impressive. But there is a flip side: Post-1997, the rollover game is finished. Now they've got to recognize their accumulated gains at the time of the sale of their current home. And that number is a whole lot bigger than they ever imagined. It's not the $150,000 apparent profit ($1.1 million minus $950,000) on the current house. Their actual gain is the total of the $150,000 current sale profit PLUS the accumulated, long-deferred gains of $825,000 stretching back to 1972, when they sold the first home. That comes to a staggering $975,000 of gains.

Even with the full $500,000 exclusion for married joint-filers, the couple still faces taxation on $475,000 of unsheltered gains ($975,000 - $500,000). Assuming a 15 percent capital gains tax rate, that comes to $71,250 (.15 x $475,000).

There are ways to minimize or avoid tax time bombs like this, and Robinson devotes a chapter of his book to them. But, he said in an interview with Realty Times, "growing numbers of people selling their homes" -- especially baby boomers -- "face some potential tax surprises" because of the interplay between the old rollover rules and the new tax-free exclusion rules.

Could Congress come to the rescue and raise the tax-free limits to help out baby boomers with billowing taxable gains? Absolutely. But don't even think about that happening soon -- not as long as the federal budget is spurting red ink with record deficits.

Published: March 1, 2004

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.