On a motion for partial summary judgment, the Tax Court held that the taxpayers did not qualify under Sec. 121(a) to exclude gain from a house they sold, because the IRS showed that there is no genuine dispute that the taxpayers did not use the house as their principal residence for at least two of the five years preceding the sale. However, the court also held that there was a genuine factual dispute on the issue of whether, under Sec. 121(c)(2)(B), the sale was by reason of a change in the health of one of the taxpayers.
Background
Steven and Catherine Webert were married in 2004. In 2005, they purchased a house on Mercer Island, near Seattle. In that year, Catherine was diagnosed with cancer. The cancer and the numerous associated health problems that she later suffered caused her to incur excessive medical bills and reduced her ability to work. This caused an extended period of financial hardship for the Weberts.
The Weberts lived in the house until 2009 and then moved to another home owned by Steven, and they put the Mercer Island house up for sale. Due to the housing crash, they were unable to sell the house and eventually began renting it. In 2015, they were finally able to sell the house, realizing a gain of $194,752. In 2016, the Weberts divorced.
On a joint return for 2015, the Weberts reported the sale of the Mercer Island house on Schedule D, Capital Gains and Losses, but they excluded the gain on the sale from their gross income under Sec. 121(a). They also reported the rental income for the home on Schedule E, Supplemental Income and Loss, as they had since they started renting the property in 2010. On Schedule E for all those years, they reported the number of days in the year they rented the Mercer Island house at fair rental value and the number of days they used the property for personal use. They also attached to each return a depreciation and depreciation recapture schedule that reported the number of days the house was rented each year, which matched the fair rental days reported on the Schedules E.
The IRS examined their 2015 return, issued a separate notice of deficiency to each of the now-divorced Weberts, and disallowed the Sec. 121 exclusion of income from the sale of the Mercer Island home. The Weberts took the dispute to Tax Court.
The IRS filed a motion for partial summary judgment in the case. It contended that there was no genuine dispute of material fact regarding whether the couple could exclude the gain from the sale of the Mercer Island house because they failed to use it as their principal residence for the requisite period under Sec. 121(a).
Steven and Catherine responded separately to the IRS's motion. Catherine did not oppose the IRS's motion, but Steven did. In his response, he asserted (but not in the form of an affidavit or declaration) that he and Catherine did use the Mercer Island house as a residence and that the reasons for the sale included Catherine's health problems.
In its reply to Steven's response, the IRS, reacting to Steven's raising of the health issue, also argued that the Weberts could not exclude any of the gain from the sale of the Mercer Island house under the separate exclusion provided under Sec. 121(c). According to the IRS, Sec. 121(c) did not apply because the primary reason for the sale was not a change in place of employment, health, or unforeseen circumstances.
Sec. 121(a) exclusion: Under Sec. 121(a), a taxpayer can exclude the gain on the sale of a house if the taxpayer has owned and used the house as a principal residence for at least two of the five years immediately preceding the sale. The term "principal residence" means "the chief or primary place where a person lives or . . . the dwelling in which a person resides" (Gates, 135 T.C. 1, 7 (2010) (emphasis omitted)). Whether a house is the taxpayer's principal residence depends on all the facts and circumstances.
The maximum exclusion of gain under Sec. 121(a) from the sale of a principal residence is limited under Sec. 121(b)(1) to $250,000 for an individual or under Sec. 121(b)(2) to $500,000 for married taxpayers filing jointly. To take the $500,000 exclusion, among other things, one spouse of the couple must meet the two-year ownership requirement for the house, and both spouses must meet the use requirement. However, under Sec. 121(b)(2)(B), if the spouses do not collectively meet the ownership and use requirements, the excludable gain under Sec. 121 is the total of the gain that each spouse would be allowed to exclude if they were not married during the time that either owned the house.
For a taxpayer who qualifies to exclude gain under Sec. 121(a), the exclusion does not apply to the portion of the gain from the sale of the home that is allocated to periods of nonqualified use under Sec. 121(b)(5)(A). Under Sec. 121(b)(5)(C)(ii)(III), periods of nonqualified use do not include a "period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or . . . other unforeseen circumstances."
Sec. 121(c) exclusion: A taxpayer who does not qualify for a Sec. 121(a) exclusion because he or she does not meet the ownership or use requirement may still be allowed a reduced exclusion under Sec. 121(c), if the "sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances." Unless one of the safe harbors in Regs. Sec. 1.121-3 applies, this standard only applies if the primary reason for the sale or exchange is one of these three reasons.
The Sec. 121(c) exclusion has its own limitation: The amount of the exclusion that might otherwise have been permitted for an exclusion under Sec. 121(a) ($250,000 or $500,000) is multiplied by a fraction, the numerator of which is the aggregate periods, during the five-year period ending on the date of such sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence and the denominator of which is two years (or 730 days or 24 months, depending on the measure of time used in the numerator). Thus, to get any exclusion under this special rule, the taxpayer must have resided in the house for at least one day.
Tax Court summary judgment rule
Under Tax Court Rules of Practice and Procedure Title XII, Rule 121, either party may make a motion for summary judgment on some or all of the legal issues in controversy in a case. The Tax Court may grant summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(d) provides when a party properly makes and supports a motion for summary judgment, the adverse party cannot defeat the motion by making mere allegations or denials of the moving party's pleadings. Instead, the adverse party must by affidavits or declarations, or as otherwise provided in Rule 121, show specific facts establishing that there is a genuine dispute for trial.
In deciding whether to grant summary judgment, the court is required to make factual inferences in the light most favorable to the nonmoving party.
The Tax Court's decision
The Tax Court granted the IRS partial summary judgment, finding that there was no genuine dispute of material fact regarding whether the Weberts met the use requirement with respect to the Mercer Island house, so they were not entitled to an exclusion under Sec. 121(a). The court also found, however, that there was a genuine dispute of fact regarding whether the primary reason for the Weberts' sale of the Mercer Island house was Catherine's health.
Sec. 121(a) exclusion: Catherine undisputedly owned the Mercer Island house continuously from 2005 through 2015, so the Tax Court determined that the only dispute in the Weberts' case regarding the primary gain exclusion under Sec. 121(a) was whether the couple met the use requirements. The IRS pointed to the Weberts' returns for the years 2010 through 2015, signed by the Weberts under penalty of perjury, as evidence of their lack of personal use of the Mercer Island house. Steven, in his response to the IRS's motion for partial summary judgment, did not offer specific factual support by affidavits or declarations or as otherwise required by the Tax Court's Rule 121 to support his claim he used the Mercer Island house as his principal residence at any point in the five years preceding its sale. He only made the general allegation in his response that he and his ex-wife used the Mercer Island house as a principal residence during the five years prior to its eventual sale.
The Tax Court determined that "this broad generalization, made in contradiction of [Steven's] own previous and specific accounting, cannot create a genuine dispute of fact." Having failed to make any actual showing that he and his ex-wife together or separately used the Mercer Island house as their principal residence for the required period under Sec. 121(a), the court found that the couple did not qualify for the exclusion of capital gain on the sale of the house.
Effect of health conditions on exclusions: The Tax Court found that Steven's response to the IRS's motion for partial summary judgment invoked both the health-related exception to nonqualified use in Sec. 121(b)(5)(C)(ii)(III) and the separate exclusion allowed in Sec. 121(c) when the sale of the taxpayer's principal residence is by reason of health. In its reply to Steven's response to its motion, the IRS claimed Steven did not show the requisite causal connection between the health problems and the absence or the sale.
The Tax Court stated that it was clear that the Weberts had "suffered many unfortunate and prolonged difficulties." Thus, it also seemed clear to the court that Catherine's health caused the couple to need to move from the Mercer Island house and was "a precipitating cause for the financial circumstances that contributed to that need." However, in his response to the IRS's motion for summary judgment, Steven did not argue that any of these difficulties fall under the Regs. Sec. 1.121-3(b) safe harbors or that they were the "primary reason" for the sale of the Mercer Island house in 2015. The court, however, did not hold this against Steven because he did not anticipate that the IRS would raise those issues in its reply.
Nonetheless, the court stated that if, as required by Rule 121, it drew all reasonable inferences in Steven's (the nonmoving party's) favor, it appeared that Catherine's health problems may have been the primary reason for the Weberts' attempts to sell the house, which began in 2009 and finally succeeded in 2015. Consequently, the court found that there was a genuine dispute of fact as to whether health reasons were the primary reason for the sale, so it could not grant the IRS summary judgment on that issue.
However, the Tax Court further found that it was not clear that the facts about Catherine's health and its effect on the sale were actually material to the Weberts' case. As the parties had not addressed this question, the court did its own analysis and concluded that Catherine's health problems did not seem to affect whether the Weberts were entitled to an exclusion of their gain on the sale of the Mercer Island house.
While a temporary absence due to "health conditions" may avoid being characterized as "nonqualified use" for purposes of determining how much gain is allocated to nonqualified use (and therefore cannot be excluded from gross income), the court found that this allocation is only done when the taxpayer determines he or she has met the ownership and use requirements. While the parties had not argued the point, in the Tax Court's view the exception to nonqualified use for temporary absences due to health conditions in Sec. 121(b)(5)(C)(ii)(III) did not override the use requirements for the Sec. 121(a) exclusion. Thus, because the Weberts did not meet the use requirement, it made no difference whether Catherine's health problems would allow any use to be characterized as nonqualified use.
In addition, the Tax Court observed that while Catherine's health problems might make the Weberts eligible for the Sec. 121(c) exclusion, that exclusion provision, as discussed above, is subject to a limitation based on use that might prevent the Weberts from excluding any of their gain from the sale of the Mercer Island house. Based on the facts before it, the court stated that the Weberts did not have any residential use during the five-year period ending on the date of the sale, and, consequently, under the Sec. 121(c) exclusion limitation formula, their exclusion would be zero. Therefore, in the absence of additional argument from the Weberts about the use of the house, a trial would not be needed to decide whether Catherine's health problems were the primary reason for their sale of the Mercer Island house.
Reflections
Based on the Tax Court's order, it would seem likely that the Weberts will prevail on the issue of whether the Mercer Island house was sold by reason of the change in Catherine's health if the case goes to trial. However, to get to trial, the Weberts will still need to prove that this makes a difference by presenting evidence that they used the house for any days during the five-year period ending on the date of the sale and, thus, would be entitled to a partial exclusion if the primary reason the house was sold was the change in Catherine's health. If the Tax Court's description of the facts regarding the Weberts' use of the house in its order is accurate, it would appear that there is little or no chance of the couple's doing that.
Webert, T.C. Memo. 2022-32
Contributor James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information on this column, contact thetaxadviser@aicpa.org.
