Normally, the tax on all or part of the gain from the sale of a principal residence may be avoided or postponed by acquiring a new residence within a 48-month rollover period.
Under most circumstances, a taxpayer must buy a new home or build another one and use it as a principal residence within two years before or after selling the old one. The length of the replacement period is modified for members of the military or people living abroad.
To benefit from the provision, the replacement home's cost must equal or exceed the adjusted sale price of the old home.
If a taxpayer does not replace the residence in time, the entire profit is taxable as a capital gain. If the cost of the new residence is less than the adjusted sale price of the previous residence, the unexpended proceeds are subject to taxation.
Example: William Klinton sells his principal residence. The adjusted sale price is $198,000. He buys a new residence for $190,000. Because $8,000 of the selling proceeds were not reinvested in a new residence within the replacement period, the unexpended proceeds must be reported as a capital gain.
If Mr. Klinton spends $8,000 or more on improvements on the new residence, and the expenditure occurs within the rollover period, he can avoid all taxes on the sale.
Replacement relief is not available in several situations.
More than one residence: You may apply the tax-relief provision only to the sale of a principal residence. If you rent your principal residence and own a secondary residence, the non-recognition provision will not apply to the sale of the secondary residence.
New residence sold before old: If a new residence is bought and sold before the old home is sold, the sale of the new residence will not qualify for replacement relief, either. Instead, the entire gain on the sale of the new residence will be subject to taxation.
More than one rollover: If more than one principal residence is bought in the rollover period, only the last is considered a new home for purposes of applying the non-recognition provision.
Non-recognition does apply to more than one sale in the rollover period if the move is job-related and the moving expenses are deductible.
Sale of residence by a trust: In many situations, a trust might be designated as the legal owner of a residence. A trust, however, cannot enjoy the non-recognition benefits of replacement relief because it is not a person using property as a principal residence.
Title in new residence held by another: Non-recognition does not apply if the proceeds from the sale of the old home are reinvested in a new home to which another party holds title. If a new residence is owned jointly by the taxpayer and a spouse, the non-recognition provision will apply.
For additional information, see IRS Form 2119.