Taxpayers Not Entitled to Exclude Gain from Sale of Principal Residence

By Stephen E. Aponte, CPA, Holtz Rubenstein Reminick LLP, New York, NY

Editor: Stephen E. Aponte, CPA

Gains & Losses

In a recent decision, the Tax Court ruled that a couple who sold a house they had never lived in could not take advantage of the Sec. 121 exclusion. That in itself is not surprising. The twist in this case was that the couple had lived in a house on that same property for years, but then tore it down and built a new house on the property that they never lived in. Although they claimed they should still be entitled to the exclusion, the Tax Court disagreed.

History of the Exclusion of Gain on Sale of a Principal Residence

Before 1951, no exclusion for gain on a principal residence existed. If a taxpayer had any gain on a sale of a residence, it was taxed as a capital gain. Realizing the hardship taxpayers could face by having to pay tax on the gain of their principal residence, especially if circumstances out of their control forced them to sell, Congress decided to provide relief. Former Sec. 112(n)(1) was enacted in 1951 to provide that relief. It provided that no gain on the sale of a principal residence would be recognized if the taxpayer purchased a new residence at a price at least equal to the selling price of the old residence within a specified time. Any gain not recognized would be deferred and used to calculate any gain on the new residence when it was ultimately sold. Sec. 112(n)(1) eventually became Sec. 1034 when the Internal Revenue Code was rewritten in 1954.

In 1964, Sec. 121 was enacted, which allowed an individual to exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) had attained the age of 55 before the sale and (2) had owned the property and used it as a principal residence for three or more of the five years immediately preceding the sale. Unlike Sec. 1034, Sec. 121 was a permanent exclusion, not a deferral of income. However, taxpayers were allowed to take advantage of this exclusion only once.

Now that both rules were in place, it was possible for most taxpayers to never have to pay capital gains tax on a sale of their principal residence. While they were under 55 years of age they could sell their home and roll the gain over into the next home that they purchased. When they were retired and ready to downsize or possibly not purchase a new home at all, they could use the one-time exclusion under Sec. 121 to exclude the gain entirely.

In 1997, Congress enacted the Taxpayer Relief Act of 1997, P.L. 105-34, which repealed Sec. 1034 and amended Sec. 121. The amendment of Sec. 121 dramatically changed the rules for the exclusion of gains of the sale of a principal residence. The current Sec. 121(a) states that gross income does not include gain from the sale or exchange of property if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more. Sec. 121(b) limits the amount of gain that can be excluded from gross income under subsection (a) to $250,000. An exclusion of $500,000 is available for married taxpayers where either spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse is ineligible to take the exclusion because they had already excluded the gain on a different primary residence during the two-year period ending with the date of the current sale. As was the case with the prior version of Sec. 121, the exclusion of gain is permanent and not a deferral. Reduced exclusion amounts are available to taxpayers who fail to meet the ownership or use test but sell their principal residence because of a change of employment, health, or, to the extent provided by regulations, unforeseen circumstances (Sec. 121(c)). The current rule continues to provide most taxpayers the ability to avoid capital gains tax on sales of their principal residences throughout their lifetimes.

The Gates Case

In Gates, 135 T.C. No. 1 (2010), all the facts were stipulated by both parties. The taxpayer purchased the home in 1984 for $150,000. In 1989, he married his current spouse, and afterward they both resided in the house until 1998. In 1996, the taxpayers decided to enlarge and remodel their home. Their architect advised them that in the years since the house had been built, new and stricter building standards had been enacted. Because of this, the taxpayers decided to demolish the house and rebuild. This made it easier for the construction to comply with the new standards.

Although the new house was completed in 1999, the taxpayers never lived there after it was built. In 2000 they sold the property, resulting in a gain of $591,406. They filed their federal income tax return in 2001 but showed no gain on the sale of the property, although they later agreed that they should have reported a gain of $91,406 after the $500,000 exclusion.

The IRS concluded that because the taxpayers had never actually lived in the new home they were not entitled to the exclusion, and it sent a notice of deficiency increasing the taxpayers’ income by $500,000. The IRS considered the term “property” for this purpose to mean a “dwelling” that was owned and occupied by the taxpayers as their principal residence. The taxpayers countered that the property sold included the land where their primary residence had been located for many years and should qualify for the exclusion. They argued that the term “property” should include not only a dwelling but the land on which the dwelling is situated.

In a decision by the full court, the Tax Court focused on the definition of the terms “property” and “principal residence.” Because Sec. 121 does not define these terms, the court had to “apply accepted principles of statutory construction to ascertain Congress’ intent” and noted that “it is a well established rule of construction that if a statute does not define a term, the term is given its ordinary meaning.” Because the court found more than one possible meaning for the terms, it could not conclude that Sec. 121 was “clear and unambiguous.” Therefore, the court found that it needed to examine the legislative history of Sec. 121 and its predecessor provisions.

After examining the legislative history, the court found that Congress intended the terms “principal residence” and “property” to mean the primary dwelling or house that a taxpayer occupied as its principal residence. They took this to mean the structure and not the surrounding land that the house sits on.

The Tax Court cited previous cases to support its decision. In Hughes, 54 T.C. 1049 (1970), aff’d, 450 F.2d 980 (4th Cir. 1971), the taxpayer had agreed to exchange property A, which included its principal residence, for property B and cash. But before the exchange the taxpayer moved the dwelling located on property A to property C to use as an income-producing property. In O’Barr, 44 T.C. 501 (1965), the taxpayer sold part of a tract of land on which the taxpayer’s principal residence was situated; however, the portion of the land sold did not include the residence. In both of these cases, the court ruled against the taxpayer and disallowed any exclusion of income. Following the precedent of these cases, a nine-judge majority of the Tax Court held that the dwelling unit, and not the land underneath it, was the “property” that should fall under Sec. 121, and the court held in favor of the IRS.

Although the majority held in favor of the IRS, there was a strong dissent by five judges. They argued that there was adequate ground for ruling that the sale of the new house qualified for the exclusion. They further argued that the legislative history the majority cited provided insufficient grounds to conclude that Congress intended Sec. 121 to apply only if the taxpayers actually used the dwelling as their principal residence.

The dissent questioned whether the standard embraced by the majority would yield the correct result if a home were destroyed by a natural disaster and rebuilt. They also noted that the distinction between a rebuilt and a remodeled home could at times be hard to make. According to the dissent, the majority’s narrow standard could unduly burden some taxpayers whom Congress intended to be allowed to take the exclusion.

The strong dissent leads one to believe that this case could be appealed. It also signals that if the facts were different—such as in the case of a natural disaster or the extensive remodeling of a home—the results could be different.


Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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