Sec. 121 Exclusion of Gain from Sale of a Principal Residence

Editor: Mark G. Cook, CPA, MBA

Gains & Losses

For generations, citizens and residents of the United States have pursued the American dream of home ownership. While purchasing a first home is a milestone in the lives of many Americans, meeting the changing needs of their families, relocations necessitated by employment, or any number of factors may compel them to buy and sell one or more principal residences over the course of their lives. As a result of changing market prices, taxpayers may realize gains or losses on the sale of their homes. Whereas losses realized on the sale of personal residences are treated as nondeductible personal losses, gains realized on those sales may be subject to income tax. Prior to 1951, any gain from the sale of a personal residence was taxed as a capital gain. The result of this policy was that taxpayers were left with reduced proceeds to reinvest in their replacement homes.

Recognizing that this caused hardship for many homeowners, particularly for those taxpayers who may have been forced to sell and relocate for reasons beyond their control, Congress granted relief from the capital gain provisions with the Revenue Act of 1951, P.L. 183, 82d Cong. (65 Stat. 452). As originally enacted, the relevant sections of the 1951 act generally provided for the deferral of gain recognized on the sale of a principal residence if a taxpayer purchased a replacement residence of equal or greater value. There have been many changes to these provisions since 1951 that have led to the current tax regime. Under current law, Sec. 121 provides that taxpayers may exclude up to $250,000 ($500,000 for joint returns) from the gain on the sale or exchange of a principal residence provided they meet certain ownership and use requirements.

This past summer, the Tax Court took up a discussion of Congress’s intent for Sec. 121 when it decided the case of Gates, 135 T.C. No. 1 (2010). In the stipulated facts of that case, the Gateses owned and used a house as their principal residence, satisfying both the ownership and use requirements of Sec. 121. In 1999, they began remodeling that house but, due to complications of retrofitting it to comply with the building code, the remodel morphed into a complete teardown of the structure and the construction of an entirely new house on the same site. Without having resided in the new house, the Gateses sold the new house along with the land it was built on in 2000, realizing a gain on the sale of $591,406. Ultimately, the Gateses reported the $91,406 gain in excess of $500,000 on their untimely filed 2000 income tax return, claiming that the remaining $500,000 gain was excludible under the provisions of Sec. 121. Upon examination of the Gateses’ return, the IRS disallowed the exclusion and issued the taxpayers a notice of deficiency. In its July 2010 decision, the Tax Court sided with the IRS.

Property Sold as a Principal Residence

In the parts relevant to this case, Sec. 121(a) explicitly states that for the taxpayer to exclude any gain from gross income under that section, the property sold must have been the taxpayer’s principal residence. At issue in the Gates case are the definitions of “property” and “principal residence.” The Gateses’ position was that the property serving as their principal residence was the land and the dwelling on it, while the IRS’s position was that the property serving as the principal residence was the dwelling. Sec. 121 does not define these terms, so the court sought to determine congressional intent to decide whether Sec. 121 should apply to the land, the dwelling structure, or a combination thereof.

The precursor law to Sec. 121 was Sec. 112, enacted in 1951. Sec. 112 addressed the issue that taxes on the gain from the sale of a home would reduce the capital available for purchasing a replacement home. Sec. 112 provided that no gain was recognized on the sale of a principal residence as long as the seller purchased a replacement principal residence of at least the same value as the property that was sold within the prescribed time period. Instead, the gain was deferred, and taxpayers had the administrative burden of tracking this deferred gain throughout their lifetimes. Sec. 112 was later redesignated as Sec. 1034.

More than a decade later, Congress enacted Sec. 121 in 1964. In its original incarnation, Sec. 121 was aimed at older taxpayers. It allowed for a one-time exclusion of up to $125,000 of gain on the sale or exchange of a principal residence if the seller had attained the age of 55 before the sale and had owned the property and used it as a principal residence for three or more of the five years immediately preceding the sale. This one-time exclusion applied to one sale, not to one taxpayer. Therefore, if a taxpayer did not recognize at least $125,000 of gain on the single sale for which he or she elected to use the exclusion, any unused portion of the $125,000 was lost and the taxpayer could not use it to offset gain on a later sale. In 1997, Sec. 1034 was repealed and Sec. 121 was broadened by removing the age requirement and the one-time limit and increasing the exclusion amount to $250,000.

All these amendments furthered the concept of providing relief to taxpayers selling their homes, but none addressed the issue of the definition of property or principal residence. However, in reviewing the notes from the House Committee on the Budget, which passed the 1997 amendments, the legislators used the terms “house” and “home” interchangeably with the term “principal residence.” The court found that the contextual usage of “house” and “home” by the legislators showed that they intended “principal residence” to refer to the dwelling structure occupied by the taxpayer. As the court noted, this position is also consistent with prior case law generated by questions raised over the now-repealed Sec. 1034.

Returning to the facts of the Gates case, the taxpayers had a home that they both owned and used for the required two of five years preceding the sale. If the taxpayers had sold that structure instead of razing it, it appears that they would have satisfied the requirements to be eligible to exclude the gain on the sale as permitted by Sec. 121. However, the Gateses did not sell the home they had lived in. Instead they sold a newly constructed house that they never lived in. Having determined that the term “principal residence” as used in Sec. 121 pertains to the dwelling structure and not the land, the court found that the Gateses failed to meet the use test regarding the dwelling structure that they sold. They were therefore required to include the gain on the sale of the property in their income for the year of the sale.

Differing Opinions

While the court’s decision favored the IRS’s position, it is interesting to note some of the points brought up in the dissenting opinion. The dissent suggested plausible scenarios in which a satisfactory decision might not result from the majority’s reasoning. In one scenario, a taxpayer, who otherwise satisfies the ownership and use tests, tears down a building, leaving the foundation. The taxpayer then constructs a new home using the original foundation. Because the foundation is an integral part of both the new and the old structures, if the taxpayer sells the newly constructed dwelling without living in it for the requisite time period, does he or she meet the use test? This begs the question of where remodeling ends and new construction begins.

A second scenario assumes that the primary residence of a taxpayer is damaged beyond repair by a circumstance outside his or her control, such as a hurricane. These circumstances force the taxpayer to build a new structure. In the process of designing the new structure, the taxpayer decides it would be more prudent to locate the new structure on a different portion of the same tract of land because that area is more sheltered from the possibility of future hurricane damage. If the taxpayer, who satisfied the requirements of Sec. 121 regarding the destroyed house, sells the replacement house without having lived in it for the requisite period, should he or she be denied the favorable tax treatment afforded by Sec. 121? Under the rule espoused by the majority, these questions cannot be answered until cases with similar fact patterns are litigated.

For the time being, the conclusion of the Gates case indicates that taxpayers must meet the primary residence, use, and ownership requirements with respect to the dwelling structure and not just the land to satisfy the gain exclusion provisions of Sec. 121.

EditorNotes

Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.