Taxpayer Denied Exclusion for Gain on the Sale of a Principal Residence

By James A. Beavers, J.D., LL.M., CPA


The Tax Court held that taxpayers who demolished a home they had lived in for more than two years, built a new home on the same lot, and then sold the new home without ever living in it were not entitled to exclude the gain from the sale from income under Sec. 121.


In December 1984, David Gates purchased property in Santa Barbara, California, for $150,000. The property included an 880-square-foot two-story building with a studio on the second level and living quarters on the first level.

In August 1989, Gates married his wife, Christina, and they lived in the original house. In 1996, they decided to enlarge and remodel the original house and hired an architect to draw up plans. The architect advised them that more stringent building and permit restrictions had been enacted since the original house was built, although it is unclear if this made enlarging the home impossible or merely economically impracticable.

Subsequently, the Gateses demolished the original house and constructed a new three-bedroom house on the property. The new house complied with the building and permit requirements existing in 1999. However, the couple never resided in the new house. On April 7, 2000, they sold the new house for $1,100,000, resulting in a $591,406 gain. At the time of the sale, the Gateses had lived in the original house for a period of at least two years during the preceding five-year period.

On their late-filed return for 2000, the Gateses did not report any of the $591,406 capital gain generated from the sale of the property as income. On audit, they agreed that $91,406 of the gain should have been included in their gross income for 2000, but they asserted that the remaining gain of $500,000 was excludible from their income under Sec. 121. In 2005, the IRS sent the Gateses a notice of deficiency for 2000 that increased their income by $500,000. The IRS asserted that they had failed to establish that any of the gain on the sale of the property was excludible under Sec. 121. In response, the Gateses petitioned the Tax Court, seeking a redetermination of the deficiency.

Sec. 121

Sec. 121 provides the rules for the exclusion from income of gain from the sale of property that a taxpayer or taxpayers have used as a principal residence. Sec. 121(a) specifies:

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.

Two of the most significant terms in Sec. 121(a) are not defined—“property” and “principal residence.” The subsection simply provides that gross income does not include gain from the sale or exchange of property if “such property” has been owned and used by the taxpayer “as the taxpayer’s principal residence” for the required statutory period.

The Arguments

The IRS’s argument focused on the term “principal residence” in Sec. 121. The IRS contended that the Gateses did not sell property they had owned and used as their principal residence for the required statutory period because they never occupied the new house as their principal residence before they sold it. According to the IRS, the term “property” means only a dwelling that was actually owned and occupied by the taxpayer as his or her principal residence for at least two of the five years immediately preceding the sale. Thus, because the Gateses never resided in the new house before its sale in 2000, the IRS maintained that the new house did not qualify as their principal residence.

The Gateses’ argument focused on the term “property” in Sec. 121. According to the Gateses, property for these purposes means both the residence and the land on which it is situated. Thus, they contended that they were entitled to the exclusion because they used the original house as their principal residence for the period required by Sec. 121(a) and sold the land on which the original house had been situated, regardless of the fact that they had demolished the original house and replaced it with a new one.

The Tax Court’s Decision

In a decision rendered by the full court, the Tax Court held that the Gateses did not meet the requirements to exclude the gain from the sale of their Santa Barbara property from income. The court found that the meaning of Sec. 121(a) was ambiguous because of the lack of precise definitions for “property” and “principal residence.” Therefore, it applied “the accepted principles of statutory construction to ascertain Congress’ intent” and held that the IRS’s position with respect to Sec. 121(a) was consistent with Congress’ intent.

The Tax Court found that under the rules of statutory construction, it was required to narrowly interpret exclusions from income. Lacking definitions for “property” and “personal residence,” it analyzed whether the terms’ ordinary meanings could be used. However, after looking at the dictionary definition of the terms “property,” “principal,” and “residence,” the court determined that they had more than one possible ordinary meaning. Therefore, the court concluded that it must look at the legislative history of Sec. 121 to determine what the proper meaning of the terms was for purposes of the statute.

Looking at the legislative history for both Sec. 121 and its predecessor statutes, the Tax Court found:

The legislative history demonstrates that Congress intended the term “principal residence” to mean the primary dwelling or house that a taxpayer occupied as his principal residence. Nothing in the legislative history indicates that Congress intended section 121 to exclude gain on the sale of property that does not include a house or other structure used by the taxpayer as his principal place of abode. Although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that Congress intended the section 121 exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a).

The Tax Court further found that its conclusion was supported by its own precedent regarding the exclusion before the enactment of the current version of Sec. 121. Thus, it held that the Gateses were not entitled to exclude the gain from the Santa Barbara property from their income for 2000.

The Dissenting Opinion

A group of five judges dissented from the majority’s opinion. The dissent argued that under the rules of statutory construction, the exclusion in Sec. 121 should not be interpreted narrowly because Congress had liberalized the exclusion (when it enacted Sec. 121 in its current form) for public policy reasons. Consistent with this rule, the dissent maintained that the IRS’s application of the law was incorrect because it would produce inconsistent results in what were essentially equivalent situations.

As an example, the court described a scenario in which a taxpayer’s long-time home was destroyed in a natural disaster. If the taxpayer rebuilt the house and sold it 18 months later, she would not be entitled to the deduction. On the other hand, if the home was heavily damaged but rebuilt, the taxpayer would be entitled to the exclusion. According to the dissent, remodeling a home and demolishing and rebuilding a home are not recognizably different situations and should not be treated differently.

To avoid problems in these situations, the dissent contended that the correct approach to the problem would be to simply treat remodeling a home the same as demolishing and rebuilding a home for purposes of the exclusion. As an alternative, the dissent suggested treating the original house as being sold for zero dollars upon its demolition and applying Sec. 121 to a subsequent sale of the land (and new house).


In a concurring opinion, eight of the Tax Court judges, replying to the dissent, pointed out that the dissent based their argument not on the case before the court but on cases that might come before the court in the future. The concurring judges noted that Tax Court precedent requires the court to decide cases “in light of what was done, not what might have been done.” While in some situations involving the application of the exclusion to a totally rebuilt home it might be fair to give a taxpayer the benefit of the statute’s ambiguity, in others it might very well not be. It would therefore seem to be more prudent, as the concurring opinion suggests, to make this decision on a case-by-case basis.

Gates, 135 T.C. No. 1 (2010)

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.