Recent Tax Court Ruling Denies IRS Sec.121 Gain Exclusion on Sale of a Personal Residence

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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)."

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.

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  1. Interesting, since when did a stick built home have wheels? obviously IRS thinks it is personal property. Why couldn’t the Gates’ seperate the house and land applying a value to both then deduct the land value from the house? IRS seemed to be more interested in “principle residence”, then the land should have no tax consequences. JT

  2. This is an interesting situation. So if the IRS will go after homeowners who sell their houses after remodeling and not dwelling in it for the prescribed minimum length of time, I’d say who not just stay in the house until the timeframe the IRS has set is fulfilled?
    Although there are definitely many situations that can apply here, I believe if a remodeling is intended for the sole purpose of selling a property, it is best to anticipate whatever tax responsibilities come your way. But if the remodel will not entail a future sale in less than 2-3 years, then I guess homeowners have nothing to worry about.
    It’s just a matter of careful planning. If the IRS counts your years of residence in the property, think about if you will be living long enough in the remodeled house before carrying out your plan.

  3. Glad I found this article – I think the court’s ruling makes sense to me. Two questions wrt Sec 121 that are unanswered for me:
    – How long is the 2 of 5 years suspension good for? as a military service member having been stationed more than 50 miles away every year since we last lived in the house (Bought and lived in from June 1997 and moved out in 2001; it has been a rental property since), I qualify for the Maximum period of suspension which states: “The 5-year period described in subsection (a) shall not be extended more than 10 years by reason of subparagraph (A).” does this mean you must reside in the house 2 of the last 15 years before sale? or is it 2 of the last 10 years?
    – What if we move back in the single family home and remodel it completely to include an enlargement that changes the house into a duplex or semi-attached multi-family dwelling? I recently found out from City records that our property is zoned for multi-family use. We want to remodel and live in one unit and rent the other unit out. I know this will re-set the clock and qualify us for gains exemption if we live there at least 2 years out of 5 before we sell both units, but does changing the original strucure from single family to dual family house disqualify us for gains exemption?
    Hope my questions make sense – it’s a bit convoluted. Am trying to decide whether we still have time until June 2014 to qualify for gains exemption or if we already lost our window for the exemption in which case we definitely need to go back and live there for 2 years to re-start the clock.

  4. A question came up similar to the above. If you own a personal residence and meet the 2 year and 5 year rules, and the original purchase price far exceeds the fair market value, you decide to short sale your home for a large paper loss, but no cancellation of debt income because the current liability was under $2,000,000. Maybe after a month or so, you buy back the same house, then because of some market miracle you can sell the home for a huge gain. Would the 2 year rule apply, even though you literally sold the home before and did not own or live in the “second time around home” for 2 years? I read where you can only have one sale every 2 years, but does that just apply to exclusion of gain? In this situation, when the house was sold the first time, there was no gain to exclude.

  5. Will R.

    Here is the link to the actual ruling:

    Really crazy decision. We are in a similar situation and are considering our options.
    1. Build new – we know for sure we will be hit with taxes
    2. Sell the house – no tax risk but money left on the table
    3. Gut and remodel – I do not think they would deny the exclusion but I guess there is risk
    4. Remodel or build new and move back in – waste of 2 years

    We will probably go with #3. I guess there is some risk there but it seems like an easy argument to win. Everyone updates their house before selling. It is a continuum. If I keep the sticks, there is no way it could be considered a new house. Here is where it gets fuzzy though… I will be keeping the side lot next to the house. But what if I sold it? Could I eat up the remainder of the $500k exemption or would that not be considered part of the sale of the house because it would probably be a different buyer/transaction?

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