Have you ever considered tearing down and remodeling your personal residence? Better be careful because the IRS is watching and what appears on its face as an innocuous event can have serious tax ramifications for you down the road. In a recent tax case the IRS was able to convince the Tax Court (Gates v. Comm’r, 135 T.C.) that tearing down and rebuilding your home should have different tax implications than just remodeling it. As most of you know, Section 121 in the Internal Revenue Code, allows for the exclusion of gain from the sale of property owned and used by the taxpayer as the taxpayer’s principal residence for two of the five years preceding the sale (The excludible amount of gain is $250,000 for single filers and $500,000 for a husband and wife who file a joint return.). Sounds simple enough right? I am sure that is what David Gates thought when started his remodel. In 1984, David Gates purchased an 880 square foot home for $150,000 in the state of California. He and Christine Gates, his wife (they married in 1989) lived in the home from August 1996 to August of 1998. At some point while residing in the home, the couple decided to enlarge their house. As plans began to take shape, the decision was made to tear-down their original home and build a new three-bedroom house on the property instead. By April of 2000, the structure was complete and the Gates decided to sell it. The newly built home sold for $1.1 million. By the time of the sale, the new structure had never been resided in by either David or Christine Gates. From the sale, the Gates received a $591,406 gain. Subsequently on their 2000 tax return, none of the capital gain was recorded in their income. It was later admitted by the Gates that $91,406 of the capital gain should have been taken into account of their 2000 gross income. In 2005, they were sent a notice of deficiency by the IRS that increased their income in the year 2000 by $500,000. They were also accused of not establishing that any gain they received on the sale of the property was excludable under Section 121. Once this case arrived before the U.S. Tax Court, it became clear that the terms "property" and "principle residence" must be defined by the court. The IRS argued that by definition in Section 121, the term "property" means dwelling. By their reasoning, because property and dwelling are one in the same, the Gates did not satisfy the requirement of living on the property for two of the minimum of five years of ownership because they did not use the new house as their personal residence before they sold it. Conversely, the Gates argued that under Section 121, the word "property" refers to both dwellings and land. They argued that the Section 121(a) exclusion applies to their gain on the sale of the property because the land its self held the original house which they used as their personal residence. They made the case that because the original house was located on the land that they sold, the exclusion should apply. The Tax Court decided in favor of the IRS To make their ruling, legislative history relating to the terms in question was used. They determined 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)." Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free The court held that Gates could not exclude from income under Section 121(a) the gain realized on the sale of their property. What does this tell me as an attorney – the Gates should have hired better counsel. This opinion is ludicrous. Based upon the Court’s opinion, is any remodeling of a home will terminate the use of that home as the taxpayer’s principal residence and resets the holding period to zero or does it require some level of remodeling before the clock is reset. What happens when a homeowner constructs a larger home on the same foundation as part of a remodel or his house burns down and he must rebuild? As you can gather the questions are many and the answers few. Hence is the situation a homeowner now finds himself if he is planning on a major remodel of his personal residence – live in the house for 2 solid years before selling to protect your 121 gain exclusion.