§1034: TWO YEAR ROLLOVER

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.

These rules are now old law which applied prior to May 7, and in certain circumstances afterwards. See 1997 Tax Act.

Old Law: The Internal Revenue Code §1034 allows a tax free "rollover" of profit on a personal primary residence into a new home purchased within 2 years before or after the sale date of the old home.

The concept is simple. To qualify, you must buy (and move into) a new home costing more than the adjusted sales price of the old home, within 2 years (before or after) of the sale of the old home. If the purchase price of the new home is equal to or greater than the adjusted sales price of the old home, tax is deferred.

If the new house costs more than the sales price (as adjusted for closing costs, brokerage fees and expenses of sale) of the old house, there is no tax due. [The cost of the new house includes capital improvements (but not furniture or draperies) made in the two year period.]

If you sell home #1 for $200,000 and incur broker fees of $12,000 and escrow fees of $2,000, you have 2 years from the sale of the old house to "roll over" the adjusted sales price of $186,000 into a new home.

If your new home costs $175,000, and within 2 years of the sale of home #1, you put in a swimming pool and tennis court for $11,000, you have spent enough to avoid all tax on the sale of the old home.

If you "trade down" into a less expensive home, tax may be owed on the portion not rolled over.

Only the sales prices count: ignore mortgages, down payments and other factors. You can buy for no money down and pocket the cash from the sale, without affecting the tax free result.

If you build (and move into) a new home (on land you own or buy) within 2 years of the sale of the old home, all costs incurred in the 4 year period (2 years before and after the sale of the old home) are eligible. If you bought the land more than 2 years before, you cannot include the cost of the land.

If you sell home #1 in 1994 and have not purchased the new home by April 15, 1995, don't worry; the sale is tax free as long as you intend to buy a new, more expensive home, within two years of the sale of the old home.

If you report on your 1994 return that you will buy the new home, but for whatever reason, you fail to replace and move into a more expensive home within the 2 year period, you are required to file an amended tax return for the year of sale, reporting the tax which would have been owed had you properly reported it at that time. Interest, and possibly penalty, will be owed.

WORKSHEET
For a Worksheet to help compute the taxable profit on the sale of your home under these old rules, see 1034 Worksheet.

The new rules are in the 1997 Tax Act.

Pre-Divorce Sale

Post-Divorce Sale

The issue revolves around whether the old home was your primary residence at the time of the sale. If one spouse is out of the home, especially for an extended period, especially if a Court Order has been obtained to keep that spouse out of the residence, the old home is no longer a primary residence.

Example: W gets a Court Order requiring H to live elsewhere. H gets an apartment. 6 months later H & W put the home on the market. Although most people claim this as H's primary residence, that is incorrect, because it is no longer his principal residence.

The old home must be your residence at the time of the sale to qualify for §1034.

FREQUENCY LIMITATION

A Frequency Limitation restricts the availability of tax deferred home trades. You may not do 2 rollovers within two years, without disqualification of the middle trade.

For example, if you sell home #1 for $100,000, and buy home #2 for $150,000, you report no taxable profit. If you later sell home #2 for $175,000 [within 2 years of the sale of home #1] and buy home #3 for $225,000, it would be nice if you could do 2 rollovers (1 into 2, and then 2 into 3).

Unfortunately, the frequency rule has been violated. For tax purposes, home #1 has been traded (tax free) for home #3. The profit on the sale of home #2 is fully taxable.

[An exception to the frequency rule is allowed if the sale of home #2 is caused by work related transfers.]

Only PRIMARY RESIDENCES qualify for this simple rollover. You cannot trade a residence for investment property, nor visa versa. If your old home was partially rented (or a home office), that proportion is ineligible for this rollover of profit. A mixed use property, such as a duplex, in which you lived in half, is treated as if it were 2 separate properties: 50% qualifies as a sale of a primary residence, subject to the liberal rules of §1034; the other 50% is subject to the much more stringent rules of §1031. [Click here for information about §1031.]

This tax-free rollover rule applies only to a primary residence, not to a vacation home.

Conversion of Use

A frequent concern is the conversion of a property from rental into a primary residence to qualify for the liberal rules for homes. Whether a property is a primary residence is a question of intent in the mind of the owner. However, should an audit arise, the IRS will look at the "objective manifestations" of that intent.

If you move into a property formerly held as rental, and the next day sign a contract to sell, the IRS will not believe your intent that the property was a primary residence, unless external facts convince the IRS that your intent justifiably changed after you moved into the new residence. In this extreme example, some objective outside event must occur, such as a change in family circumstances (e.g. discovering triplets are due).

Without some outside event, how long must you occupy the former rental property before deciding to sell it as your residence? There is no IRS requirement (other than at the time of sale it must be your residence), but we like to see the property reported on at least one tax return filed with that address. In other words, if you move in on December 31, 1993, we suggest that you do not try to sell it until after filing your 1993 Returns.

See conversion

Temporary Rental

BASIS

• To illustrate, if Joe bought a house on 1st Street for $45,000, spent $10,000 in improvements to the house over ten years, and then sold it for $95,000 (when he bought 2nd Street for $100,000), his profit from the 1st Street property was $40,000. [$45,000 + $10,000 = $55,000 cost. Sold for $95,000, less $55,000 cost = $40,000 profit.]
• 2nd Street is treated as if it cost Joe $60,000. [$100,000 cost, less deferred profit of $40,000.]
• Joe spent $20,000 on improvements on 2nd Street, and years later sold it for $150,000, buying 3rd Street for $160,000.
• Joe owes no tax on the sale of 2nd Street, because he rolled over the sales price into a new home costing at least as much as the sales price of 2nd Street. But what is Joe's tax cost of 3rd Street? $90,000. [Initial tax cost of 2nd Street was $60,000. Plus improvements = $80,000. Tax free sale at $150,000 means that $70,000 profit was deferred. The cost of 3rd Street, reduced by the deferred profit, is $90,000.]

STEP-UP IN BASIS

If you and your spouse hold title as Joint Tenants, at the death of one spouse, only one-half is inherited and receives a step-up in basis; the other half retains its historical basis.

However, if you and your spouse hold title as Community Property, at the death of either spouse, both halves receive a step-up in basis.

This is a major advantage of Community Property. For more information, see Community Property.

OVER-55, ONCE IN A LIFETIME RULE

These rules are now old law which applied prior to May 7, and in certain circumstances afterwards. See 1997 Tax Act.

Old Law: If you or your spouse are over 55, you might be eligible to exclude up to $125,000 of profit from the sale of your residence (in which you resided for 3 out of the 5 years before the sale).

One spouse must meet all 3 requirements: age, ownership, and residence.

This benefit may be used only once. If you or your spouse ever took advantage of this rule (even before marriage), both of you are disqualified, as long as you are married, even if you only used it partially (to protect less than $125,000 of profit).

The Over-55 Rule and the rollover of primary residence may work in conjunction as follows:

1. First compute the potential profit if you do not buy a new home. Reduce the adjusted sales price by the cost basis and the first $125,000 of profit. This is your potentially taxable profit.
2. Second, compute the target purchase price to avoid all tax: adjusted sales price (sales price less costs of sale) less $125,000.
3. Third, if you buy for less than the target cost (to avoid all tax) some portion may be taxable.

   That taxable amount is the lesser of:
   1) total profit and
   2) the shortfall under the target price to avoid all tax.

1. Step 1: Determine Profit:
   If you sell your home which cost $35,000 for $245,000 (and incur $10,000 costs of sale), you have $200,000 profit. [Adjusted sales price of $235,000, less cost.] If you qualify, $125,000 of profit is forgiven [Over-55 Rule], leaving $75,000 potentially taxable profit.
2. Step 2: Determine Target Cost for Rollover:
   Adjusted sales price of old home, $235,000, less $125,000 exclusion, equals $110,000 target price of the new home to avoid all tax.
3. Step 3: If you buy for less than $110,000, the lesser of your total profit [$75,000] or the amount below the target [$110,000] is taxed.

• If the new home costs more than $110,000, nothing is taxable.
• If the new home costs $80,000, the reduction below the target price is $30,000 [$110,000 -$80,000]; the profit is $75,000; $30,000 (the lesser of $30,000 or $75,000) is taxable.
• If the new home costs $30,000 it does not save any taxes. The reduction below the target price is $80,000 [$110,000 - $30,000]; the profit is $75,000; $75,000 (the lesser of $80,000 or $75,000) is taxable.

For a Worksheet to help compute the taxable profit on the sale of your home, see 1034 Worksheet.

The above information was changed by the 1997 Tax Act.

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