Question: My husband and I have owned our current home for over 5 years. We purchased it at $460,000, and find its value today is around $960,000, putting us at the $500,000 gain mark. We are not interested in moving to a different home now, but likely will want to sell our home in 15 years when our children are grown and we are getting ready for retirement. I dislike the idea of having to pay taxes on any gain we receive assuming our selling price in the future will be more than $960,000.
As we understand the law, if we would sell our present home today, and buy the house next door for $960,000, then in 15 years we would be able to sell that home for at least $1.460 million without having to pay any taxes on the gain. That would allow us to use our $500,000 tax exemption today on this house, then again on the future home, in effect getting $1 million of gain tax-free. If, however, we do not move and we sell our current home in 15 years for $1.460 million, assuming the tax law does not change, we will owe capital gains on $500,000 of our $1 million gain.
My question is, could we sell our current home to my parents (or a third-party holding company) for $960,000, report the $500,000 gain as tax-free, then a week (or month) later, purchase the home back from them for $960,000? Then in 15 years when we sell, our basis in the home will be $960,000, ensuring that a selling price of $1.460 million would give us another $500,000 of gain tax-free? The only downfall I see to doing this is the costs associated with the paperwork (mortgages, etc). Does anything in the law prevent this transaction, and what are your thoughts?
Answer: Nice try. But I don't think your plan will work. You are correct in your understanding of current tax law. Since you and your husband file a joint tax return, and have lived in the house for two out of the previous five years, you can exclude up to $500,000 of gain. In your example, you can sell your house for $960,000 and -- with one exception -- will not have to pay a single penny of tax.
One word of caution: is this your first house? Or did you use the old "roll-over" law which was in existence prior to 1987? Let's look at this example. In 1980, you bought your first house for $100,000, and sold it for $200,000 in 1984. Within two years from the date of that sale, you purchased another principal residence for $300,000. Under the roll-over rules, although you paid $300,000 for the house, you deferred $100,000 worth of profit, and thus for tax purposes the basis of this new house was $200,000. In 1986, you again sold your house, this time for $400,000, and rolled in over into your present house, for which you paid $460,000.
Your basis of the new house is not what you paid for it. Since you made $200,000 when you sold the previous residence, but did not pay any capital gains tax, the basis of your new house is only $260,000 ($460,000 - 200,000).
Thus, in your example, if you were to sell your current house for $960,000, your total gain is really $700,000. You can still exclude $500,000 of this gain, but will have to pay capital gains tax on the $200,000 difference. At the 15 percent federal tax rate, you will owe Uncle Sam $30,000, and will also have to pay state tax at whatever rate the state imposes.
For this column, I will consider that you do not have a "roll-over" problem.
You want to sell the house to your parents or to a third-party holding company, and then buy it back.
There is a legal concept in tax law which you must consider, called the "step transaction" doctrine. This is a doctrine which some legal scholars have said is both "feared and respected" by tax practitioners.
The doctrine -- which is not in the tax code, but has been developed by the courts -- allows the Internal Revenue Service the right to carefully analyze all the steps in a transaction, to determine how to treat that transaction. In effect, the IRS can look at all of the "steps" to determine whether each step stands alone or whether they will all be treated as part of one single occurrence.
In your proposal, you plan to sell the property to a friendly third party, and then shortly thereafter buy it back at the same price. I suspect that the IRS will use the step doctrine and collapse all of the steps; in other words, they will see that as a prearranged plan to avoid having to pay capital gains tax. And your plan may very well be disallowed by the Service.
You can avoid a negative response from the IRS by crafting a complete arms-length transaction with your parents. Let them buy the house for your purchase price. You will then be able to exclude your $500,000 gain.
But if you plan to stay in the property, you should sign a standard residential lease, whereby you pay your parents a fair market rent for a long period of time. There should be no mention -- in writing or orally -- that your real objective is to get the house back as soon as possible.
A few years from now, your parents can sell the property back to you, but it would have to be at the then fair market value -- less of course the amount of any real estate commission which will not have to be paid. You should understand, however, that if your parents sell the house back to you down the road at a profit, they will have to pay a tax, in an amount that is dependent on whether the gain is short-term or long-term.
If the IRS audits and rejects your plan, you will not only have to pay the tax on the $500,000 that you attempted to shelter -- namely $75,000 -- but you may also have to pay a penalty and interest.
In my opinion, it just is not worth the effect unless you have a true arms-length transaction with your parents.
