Pro-Rated Tax Free Exclusion
Note: This is the email exchange to which I referred in my item on the Tax Gap and how people intentionally overpay their taxes rather than risk IRS hassle.
Subject: Property sale
Dear Mr. Kerstetter,
I had written to you once about a year ago regarding the sale of primary residence with under 2 years occupancy. You said that it sounded like I had a good case if I chose to sell my house under 2 years.
I am in the Marines and was transferred to Yuma, Arizona in February 2004. I signed a contract to build a house in December 2003 which was completed 15 August of 2004. When I purchased this 4BD/2BA 1768 sq ft home, it was with in mind that only my domestic partner of 2.5 years and myself would be residing there full time with occasional visitations from our children. We each have a son and daughter from previous marriages for a total of 4 children.
After moving to Yuma, Arizona in February of 2004 my son came to live with me at the demand of his mother in March 2004. In June 2004 both of my domestic partners kids came to live with us full time and we moved into the house on 15 August 2004. A custody battle arose over my son and daughter in August of 2004 due to the mother wanting my son back and both kids wanting to live with me due to an unstable and hostile home at their Mother's. I was granted temporary custody of my son at that time until the custody hearing was completed.
With 3 children living with us full time now and my daughter coming for visitations it quickly became apparent the house was going to be crowded with all 4 children living there, only 1 bathroom between them, and my son needing his own room now that he was a teenager.
In February of 2005 (This was about the time in which I e-mailed you before.) I signed another contract to build a house 5BD/2.5BA 2261 sq ft. to be completed in December 2005. The final hearing was in May of 2005 and I was granted custody of both children beginning June 2005.
I sold the old home 23 November 2005 and closed on the new house on 9 December 2005. (I resided in the house I sold for 15+ months.)
I bought the first house for $147,000, owed $130,000, and sold it for $269,900. Gross gains = $122,900. I left the money with the title company until closing on the new house.
I bought the new house for $265,000. I at first was going to finance $130,000 and put all the proceeds from the 1st house into the new house, but thought best to finance another $20,000 for possible capital gains tax. $115,000 from the old house rolled right into the new house at the title company I never touched it and I received a little over $20,000 back from the title company due to financing more to cover taxes just in case.
I received a 1099 from the Title company for gross amount of $269,900.
My question is; does this still sound like a good case for a pro-rated exemption under "unforeseeable circumstances"? Should I request a private letter ruling or am I just wasting my time and money? (Apparently there is fee of $200 or ?more? to do a request.)
I have consulted the military base tax center, done exhausted reading online, and even called the IRS 1 (800) number and am even more confused than I was before. I appreciate any help or guidance that you can provide.
It still sounds as if you would qualify for the pro-rated exclusion, which any properly experienced tax professional should be able to confirm.
It's not necessary to get prior approval from IRS. Just attach a statement of the facts to your 1040.
The residence sale rules don't have any restriction on use of the cash or requirement to reinvest anything. That's only required for 1031 exchanges of business and investment properties.
The fact that you did buy a larger house to accommodate the unexpectedly larger family should be included in your explanation of why you qualify for the pro-rated exclusion.
Thank You for responding to my letter Mr. Kerstetter.
I was close to just surrendering and paying the capital gains tax to avoid having to pay any penalties or fees.
I just have one more question if you have the time to respond.
If the IRS finds that I do not qualify for a pro-rated exclusion and it's after the 15th of April or even 2 years later will I have penalties or be fined more money?
In the extremely unlikely (perhaps one in a thousand) chance that IRS questions your eligibility to use the pro-rated tax free exclusion, it's not an automatic requirement to pay the additional taxes. You and your representative will have plenty of opportunity to present more information to convince them that you are correct. Worst case scenario, if you are unable to convince them and don't want to drag it on, you would have to pay the extra Federal and Arizona taxes and interest on those taxes. Penalties are negotiable, and it shouldn't be hard to have them waived in a situation like yours.
If, on the other hand, you choose to not take any chances and pay those taxes with your original returns, there is absolutely zero chance that IRS will come back and tell you that you didn't need to. It is also the case that if you pay the taxes and then later change your mind, it will be practically impossible to get that money back. IRS will use your original self assessment of tax as an admission that you owe it, and it will be a hundred times more difficult to change that after the fact. It's the same as a murderer trying to recant a confession.
Your case is a perfect example of why I have long contended that, contrary to popular opinion that everybody is a tax cheater, more people intentionally or accidentally overpay their taxes than underpay. Millions of people are just like you, looking for 100% assurance that their position is sound and will not ever be questioned by IRS.
As I have said for decades, tax law is at most 10% black and 10% white, with the other 80% as gray as can be. My position has always been that things falling into the gray area should be interpreted in favor of the taxpayer. Unfortunately most other tax preparers and taxpayers themselves prefer to interpret the gray areas in favor of the IRS in the hope that this will buy them some safety from attacks. I have many cases over my career where people have still been attacked by IRS, even though they intentionally overpaid their taxes by several thousands of dollars; so that scenario isn't a guarantee of safety.
It's obviously your choice which way to treat this. I hope I've given you some food for thought before you send in your 1040.