The CPA Journal

IRS closes Loophole for Deemed Sale Election with Home Sale Exclusion

By N. Ron Friedman

IRS Revenue ruling 2001-57 (Internal Revenue Bulletin 2001-46) forewarns taxpayers that they cannot combine the deemed sale and repurchase capital gains election with the home sale exclusion. If they elect the deemed sale for an appreciated principal residence, the gain will be recognized and taxed but the home sale exclusion will not apply.

Under IRC section 121, taxpayers that sell a principal residence may exclude up to $250,000 of gain ($500,000 for qualified married taxpayers filing jointly) if they owned the home and used it as a principal residence for at least two of the five years preceding the sale date. The full exclusion is available only if the exclusion has not been exercised on a previous home sale within a prior two-year period ending on the sale date.

The Taxpayer Relief Act of 1997 (TRA 97) cut the maximum capital gains rates to 20% (10% for individuals in the 15% tax bracket). The act also provided for special lower rates for post-2000 transactions for property held for more than five years. Starting January 1, 2001, the maximum tax on qualified five-year property has been reduced to 18% (8% for individuals in the 15% tax bracket). However, the holding period rules for the new rates are dissimilar in two major respects:

Gain that would otherwise be taxed at 10% is taxed at 8% if realized on five-year property sold after December 31, 2000.
Gain that would otherwise be taxed at 20% is taxed at 18%, if realized on five-year property first held after December 31, 2000. Thus, the 18% rate does not apply to sales made before January 1, 2006.

Under TRA ’97, an irrevocable election (deemed sale and repurchase election) to recognize capital gain on assets acquired before January 1, 2001, is permitted in order to qualify those assets for the 18% capital gain rate. Under this election, the asset is treated as having been sold on January 1, 2001 (or the next business day), at its fair market value and then reacquired on the same day.

At first glance, this election would appear to allow taxpayers to claim the home sale exclusion twice for the same home. A taxpayer could exclude the first $250,000 (or $500,000) paper gain on the January 1, 2001, deemed sale and repurchase, step up the home’s basis to its fair market value on that date, wait two full years, sell it, and exclude any additional gain (up to $250,000 or $500,000) under IRC section 121. Thus, IRS Revenue ruling 2001-57 appears to have been issued as a warning to taxpayers not to try using this election-exclusion combination when filing their 2001 tax returns. The IRS noted that TRA ’97 specifically states that “not withstanding any other provision” of the IRC, gain will be recognized on the deemed sale and repurchase election.

N. Ron Friedman, CPA, is at Rosenberg Neuwirth & Kuchner and a member of the NYSSCPA Taxation of Individuals and Personal Financial Planning committees.

Editors:

Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

Stephen Sacks, CPA
Ernst & Young LLP

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