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This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

IRS REJECTS "DEEMED SALE" FOR PERSONAL RESIDENCE

If you are a tax aficionado or on the cutting edge of real estate developments, you may have heard of a strategy recently suggested.

First we need the background. In the 1997 tax law there was a new provision for very-long term capital gains. Assets acquired after 12/31/2000 and held for more than 5 years qualify for a special 18% tax rate. Congress decided to allow assets owned before that date to qualify for future profits, IF you elect to be taxed as if you had made a "deemed sale" on 1/1/2001 and pay tax on your built-in profits.

Here is how it works: You own XYZ stock; it cost $10 in 1977 and is worth $40 now. On your 2001 return you elect to make believe that you had sold the stock for $40 on 1/1/2001, and pay the tax (regular long term capital gain) on the $30 built-in profit.

That stock is then treated as if you had bought it for $40 on 1/1/2001, and future profits are eligible for the special 18% rate (if you hold it another 5 years).

Let's apply this to a personal residence. My wife and I bought our home in 1997 for $400,000. It is now worth $700,000. If we elect to recognize the profit in a deemed sale on 1/1/2001, what happens? We have $300,000 profit.

Now here is the interesting part. How much tax is owed on that $300,000 profit? Does the deemed sale qualify for the $250,000 / $500,000 exemption for profit on the sale of a personal residence?

Remember the rules for excluding profit on the sale of your home:

1. We lived there for at least 2 years in the last 5 years before the (deemed) sale.
2. We owned it for at least 2 years in the last 5 years before the (deemed) sale.
3. We have not sold a home tax free in the last 2 years.

• (For more on these rules, see Tax Law for Home Sellers )

We are married and file a joint return. We would qualify to exempt $500,000 of profit in a real sale. Is the deemed sale profit exempt? It should be!

Here's an illustration which may help.

We make the election, exempt the $300,000 profit, and our new basis (for income taxes) is $700,000. In 2010 we sell for $1,050,000. The profit of $350,000 (after the deemed sale) is tax free (because we meet all 3 tests again)!

If we had not made the deemed sale election, our $650,000 profit at the real sale (from our initial cost of $400,000) would be only partially tax free; the extra $150,000 would be taxable.

There is 1 small risk: If we make the deemed sale election we cannot use the home seller rule for the next 2 years (until 1/1/2003) (unless we meet an exception to the rule allowing use of the tax free sale no more frequently than 2 years).

Here is the potential problem. We make the election [to treat the home as sold (and bought back) on 1/1/2001], exempt our $300,000 profit, and our new basis in the home is $700,000.

Then we sell the home (for real this time) 11/1/2002 for $770,000. What happens?

We DON'T meet the tests to exempt any new profit, because we sold a home tax free within the last 2 years. (See rule #3 above.) This means that the profit ($70,000) since the deemed sale will be taxable.

What if we had not made the deemed sale election? At the real sale, our $370,000 profit would be completely tax free.

There is a solution:

Remember, the sale is deemed to be made on 1/1/2001.

How do you make the election? On your 2001 1040. When is your 2001 1040 due?

With extensions, you can delay filing (and making the election) until 10/15/2002. If you make the election by filing 10/15/2002, deeming the sale to have occurred 1/1/2001 and you are again eligible to sell the home tax free 1/1/2003, you are almost at that point before you have to make the election.

So, we are ready to file our 2001 return on 4/15/2002 but instead get the extensions and delay filing until 10/15/2002. By that late date, we can have a pretty good idea if we might be selling before 1/1/2003 when we would be eligible to sell again (after the 2 year period has expired).

Now the news: IRS has issued Revenue Ruling 2001-57 announcing the IRS position that the deemed sale does not qualify for the tax free sale of a personal residence. Congress passes law; the IRS enforces them; the Courts interpret them. Personally, I disagree with the IRS position; I think that although it was clearly not what Congress intended, the exact language of the law allows this technique. Unfortunately, by the time the courts decide what the law means, it's too late to do it. And until that happens, the IRS says the deemed sale is fully taxable!

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