Remodel or Rebuild? How the Decision Could Affect the Sec. 121 Exclusion

By Craig Lash, CPA, AKT LLP, Escondido, CA

Editor: Michael D. Koppel, CPA, MSA, MBA, PFS, CITP

Gains & Losses

A recent Tax Court decision forces practitioners to reexamine the types of questions they ask a client during tax planning or their annual tax interview if the client has sold his or her personal residence. Gates, 135 T.C. No. 1 (2010), turned on what may be a debatable point regarding the applicability of Sec. 121.

With regard to the sale of a home, the typical tax organizer will ask for basic information, such as the date the home was sold, acquisition date, selling price, original cost, cost of improvements, and any selling expenses. Questions about residence will most likely be included, such as whether the taxpayer personally occupied the home for at least two of the five years preceding the sale. A copy of the closing statement is also generally requested.

Because of the nature of the transaction and the potential tax impact, a practitioner may receive a phone call from his or her clients before they actually sell the home, as they most likely will be anxious to know how the sale will affect their tax return. Asking additional questions at this time could prove to be extremely beneficial, particularly if the clients have made significant improvements or renovations to their home.

If clients report that they have sold their home, they have owned the home for at least two years during the five years ending on the date of the sale, the home has been their principal residence since the date they purchased it, and they have not excluded from income any gain on the sale of property in the last two years, the practitioner may think it would be safe to assume that they qualify for the exclusion of gain from sale of principal residence under Sec. 121. However, this may not be the case.

Background on Gates

Before examining why this may not always be the correct assumption, it would be helpful to review the Gates decision. The taxpayer purchased a property that included a residence for $150,000 in 1984. In 1989, the taxpayer married. In 1996, the couple wanted to enlarge and remodel the original house, but due to stricter building and permit restrictions since the house was originally constructed, they chose to demolish the original house and in 1999 constructed a new three-bedroom house on the same property. In 2000, the taxpayers sold the new house, in which they never resided, for $1,100,000. The sale resulted in a $591,406 gain to the taxpayers. The couple did not report any gain from the sale of the property as income on their 2000 tax return. The taxpayers later agreed that they should have reported $91,406 of the gain on their tax return but said they were entitled to the $500,000 exclusion from income under Sec. 121.

The IRS disagreed with this argument and issued the taxpayers a deficiency notice that increased their income by $500,000, stating that they had failed to establish that any of the gain was excludible under Sec. 121. The IRS argued that the construction of the new home disqualified the residence from meeting the Sec. 121 requirement of its having been occupied as the taxpayers’ principal residence for at least two of the five years ending on the date of the sale.

The key word here is “residence.” There is no question that the original home, had it still been standing, would have qualified for the exclusion of $500,000 of gain from the sale of a principal residence. The taxpayer had owned the original home for over 15 years and the taxpayers together as a married couple filing a joint tax return had owned it for over 10 years; they had occupied the original home as their principal residence until it was demolished; and, it is assumed, they had not used the Sec. 121 exclusion for any other property in the past two years.

The IRS argued that the construction of a new residence on the same property as the original residence disqualified the sale from the exclusion. It noted that Sec. 121 does not define the terms “property” or “principal residence.” The IRS’s argument stated that property means, or at least includes, a dwelling. In this case the taxpayers did not occupy the dwelling itself for at least two years within the last five years ending on the date of sale.

Because Sec. 121 does not define “property” or “principal residence,” the court was forced to look at the ordinary meaning of the terms and to legislative history to determine Congress’s intent. The court ultimately held that Congress intended “principal residence” to refer to the primary dwelling or home occupied by the taxpayers as their residence. While the court agreed that a principal residence does include the property and land surrounding the dwelling, the intention of Sec. 121 was that the exclusion applies only if the dwelling sold was actually used as the principal residence for the time period required by Sec. 121(a). Because in Gates the taxpayers never resided in the new home before it was sold, they were not entitled to the exclusion of the gain from sale under Sec. 121.

Clearly this is not a taxpayer-friendly result. While excluding the entire gain from the sale of the home was never possible in this case, the taxpayers did not choose to use an alternative argument that was discussed in the dissenting opinion.

An Alternative Argument

The dissenting opinion in the case suggested that an alternative argument could have been made that the sale should have been treated as analogous to two sales of a divided parcel of property. Previous case law (e.g., Bogley, 263 F.2d 746 (4th Cir. 1959)) and Regs. Sec. 1.121-1(b)(3) have established that the exclusion allowed under Sec. 121 can be used if (1) the principal residence contains improvements and land that were partially disposed of in a prior sale and (2) there is a subsequent sale of the remaining improvements and land. Based on this, the dissent argued that the demolition of the original house could have been treated as a sale for zero dollars. The subsequent sale of the reconstructed home then could have been treated as the subsequent sale of the land, and the taxpayers could have allocated a portion of the gain to the land, which would have qualified for exclusion under Sec. 121. However, this treatment would certainly be challenged by the IRS, and at this point there is no clear indication that anyone other than the dissenting judges in the Gates case would be inclined to accept it.


This case brings up interesting and difficult interpretive questions that have yet to be answered. The big question is, Where is the line drawn between remodeling and demolishing and building a new home? For instance, does demolishing a home and building a bigger home on the same foundation constitute remodeling or rebuilding? What about keeping part of the foundation intact from the original home and expanding horizontally—does this set the clock back to zero with regard to the time requirement under Sec. 121(a)? It appears there are no clear-cut answers to these questions; should they come up for debate in a case before the court, they will be decided based solely on the facts and circumstances specific to that case.

It is safe to say that the action taken by the taxpayers in this case is an example of rebuilding and not remodeling, and the court’s definition of principal residence as a dwelling explains why it disallowed the exclusion of gain from the sale of their home. While tax practitioners many not commonly see the circumstances here when deciding how to report a transaction, home improvements and renovations are far more common. If the taxpayer has made significant home improvements, practitioners should obtain more details as to the nature and extent of the improvements, as this may drastically change the amount of gain to be included as income on the client’s tax return.


Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

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