Tricky Tax question on sale of primary residence.

27 Replies

So I will begin by saying I have already spoke with my CPA regarding this. I am here for second opinions from other wise investors and CPAs. 

I purchased a home 9 months ago to live in with my wife. Shortly after I bought the home I was approached by a developer who wanted to buy the entire street, demolish all the houses and build commercial. We are now about to close on the deal and will have a sizable gain on the sale. My original understanding was the gain from the sale of a primary residence is:

Not taxed if you live there for at least 2 of the last 5 years.

Taxed at cap gain rate(15%) if you lived there 1 of the last 5 years. 

Taxed at ordinary income if you lived there for less than 1 year. 

The IRS refers to the above as the "eligibility test"

And that is what my CPA told me. However I began to research some on my own and found IRS publication 523. In this publication they state "If you don't meet the eligibility test, you may still qualify for partial exclusion if you moved because of work, health, or an unforeseeable event.

The publication then goes on to say Important factors for determining if an event is unforeseeable are:

1) The situation causing the sale arose during the time you owned the home, and used the home as your residence. 

2) You sold you home not long after the situation arose.

3)You could not have reasonably anticipated the situation when you bought the home. 

4) You began to experience significant financial difficulty maintaining the home.

5) The home became significantly less suitable as a main home for you and your family for a specific reason. 

 I very strongly meet #1,2,3,&5  4 would be a stretch but could be claimed if I worded it right. 

Now to my question. Now what? If I believe I meet the unforeseeable partial exclusion. Do I I have to ask for permission from the IRS. Do I just not pay the tax and keep all the documentation I can in case of an audit. DO I pay 15% cap gains rate on it or do I pay no tax on it?

Even my CPA is not 100% sure on the law. there seems to be a whole lot of grey area on this one. Can one with experience with this or better understands the law please shed some light!

I have read many great accounting articles on BP from Brandon Hall. Brandon Im hoping you have a key word alert set up for your name and can help :). 

everyones 2 cents are welcome!

Tagging @Brandon Hall for you.

I'm a CPA as well, but would have to do significant research on this before I could answer it.  Brandon very likely knows the answer off the top of his head

@Linda Weygant thanks for the mention!

@Jered Sturm I do have key word alerts set up for my name and I appreciate your kind words!

Unfortunately, I take the position that this sale will not qualify for the "unforeseen circumstances" test as the developer buying up the neighborhood improves your financial position. Additionally, "unforeseen circumstances" is the hardest test to qualify for as there is a lot of grey area in the code and rulings (the other two tests are employment and health).

Per Reg. Sec. 1.121-3(e)(1):

In general. A sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. A sale or exchange by reason of unforeseen circumstances (other than a sale or exchange deemed to be by reason of unforeseen circumstances under paragraph (e)(2) or (3) of this section) does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.

The gains will be subject to capital gains tax instead.

Hope this helps!

I would try to get a private letter ruling before filing. Might be good to bring in a specialist in addition to your accountant to see what they think as far as cost/benefit for putting the process together.

I think that 3 will be the most difficult to prove because it's not that crazy for someone to want to buy your property. If I were a commissioner I wouldn't even factor that they wanted to buy every house on the block. Was the sale forced or was there eminent domain involved?

Here's a link to an article with unforeseen circumstance examples -- all involve a clear hardship.

I prepare taxes but haven't had this one come up yet :)  Good luck.

Pretty sure a financial windfall isn't going to fall under the unforeseeable exclusion...it is a decision you made voluntarily, for a gain.  Be happy paying the cap gains tax on an unexpected profit.

@Brandon Hall

 Thank you for taking the time to look into this for me. Your information is very helpful. 

you quoted

"A sale or exchange by reason of unforeseen circumstances (other than a sale or exchange deemed to be by reason of unforeseen circumstances under paragraph (e)(2) or (3) of this section) does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances." 

Although I am going to have a sizable gain on the property that is not the primary reason I am selling my home. If I decided not to sell they would have developed around (between a goodyear tire and a Kroger to be exact) my home making it unstable for a typical home. 

One question I can not seem to find the answer to is, what do I need to do if I want to take the partial exclusion. Is this something I have to have approved by the IRS to take or is it something I do and just keep as much documentation to back my case in the event of an audit?  

Some of the documentation I can get/have is the following:

- A Freddie mac affidavit that released me from the 1 year owner occupied period. I purchased the home from the home steps program where I agreed to live in the home 1 year. I was legally released from that obligation due to the development happening around me. 

-Site plans for the development

-A letter from the development company stating I couldn't have know about the development before purchasing. 

@Tim Butters

That is a good idea but first like I asked brandon above I would like to understand the process of how one utilizes partial exclusion. 

as for eminent domain. No I don't believe so. It was not forced. It is a privately owned company that is developing from residential to commercial. My neighbor actually held out and didnt want to sell now his house is going to have a good year to his right, Kroger to his left and a 8 foot concrete wall in his back yard. the lot alone is too small to do anything commercial with so now his house/ property is worthless as a house. 

So no one forced me to do anything but I know I didnt want to be that guy like my neighbor now is. 

@Tatyana S.

 Thank you very helpful!

@Linda Weygant Thank you!

@Wayne Brooks

 & @Brandon Hall

You both say  the gains will be subject to capital gains tax. Im assuming you are saying this would fall under the short term capital gains tax which is  = ordinary income rate. 

A follow up question I have for that is does the gain of the home move my tax brackets?

for example If in 2015 my wife and I (filling joint) made 100k at our 9-5 job and made another 100k gain on the sale of the home in 2015 would we taxed at the $100k income bracket or the $200k income bracket?

@Jered Sturm

To answer your most recent question - it will push your AGI and taxable income up $100k, and therefore you will likely move up brackets. 

The partial exclusion is generally based on the number of days you lived in the home as your primary residence divided by 720 days (two years). So your pro-rated percentage of the $500k exclusions (if married filing joint) will be 37.5% ([9x30]/720), or $187,500. 

With the new information, I may be swayed to think you'd have a small shot at convincing the IRS your property value would decrease after the development took place. It would be even better if you could get an accurate market estimate on your old neighbor's house for further proof of the declining property values due to the new development. 

My take is that you don't need approval. You'll file with a partial exclusion and keep documentation.  Also, yes to short-term capital gain and yes to moving up the tax bracket.

Wow @Brandon Hall  you are the man! If you were in Ohio you would have my business! Thank you for shedding so my light on the subject. Much more than my own CPA was able to. 

The only question I still have is:

What do I need to do to take advantage of the partial exclusion? Is it something I have to apply for or do I simply just not claim the gain of the sale and have all the documentation I can get in case of an audit. 

Here is where I stand currently:

I know that the event was unforeseen. Just because the unforeseeable event had a positive effect does not make it unforeseeable. @Wayne Brooks  If the fact that there is a gain ("windfall") makes it not eligible for the partial exclusion then whats the point of having the unforeseeable section at all? no one with a loss needs it.  My reason for selling is the development. The windfall/gain is just an effect of it. look at it this way. The development could have happened with out me gaining but the gain could not have happened with out the development. Both were unforeseeable. The IRS law has so much grey area that no one truly knows. And if it comes down to taking my chances. I will take my chances because not only do I feel im right I know that my chances of an audit are slim. 

I have to say thank you to all of you for helping me out on this process your knowledge is much appreciated! 

Originally posted by @Tatyana S. :

My take is that you don't need approval. You'll file with a partial exclusion and keep documentation.  Also, yes to short-term capital gain and yes to moving up the tax bracket.

I too would generally say you don't need prior approval, however if there isn't a statute, regulation, court decision, revenue ruling, revenue procedure or notice that can be utilized to to support the basis, then we are treading in grey areas and should proceed with caution.

@Jered Sturm a Private Letter Ruling (PLR) may be an okay route to take (if the IRS even takes it) but as with anything, it comes with a cost. 

Generally, you will not report the sale of your main home on your tax return, unless: you have a gain and do not qualify to exclude all of it; you have a gain and choose not to exclude it; or you received Form 1099-S. If you need to report the gain, you will complete Form 8949. 

"If the fact that there is a gain ("windfall") makes it not eligible for the partial exclusion then whats the point of having the unforeseeable section at all?"

"Unforeseeable events" is generally geared toward those who experience economic hardship unexpectedly. this will make your case harder to sell, though not impossible. Just be prepared to fight dirty if you are ever audited. 

"If you were in Ohio you would have my business! Thank you for shedding so my light on the subject. Much more than my own CPA was able to."

Technology man! I have clients all over the U.S. The only thing I wouldn't be able to do is shake your hand (though plenty of people prefer a local CPA and there's nothing wrong with that).  

With the explanation your argument is better and but I would still have trouble signing the return. If you do get audited and the tax court disagrees, the penalties could be significant, which you would then come sue me for.

Tough call, but I feel like I would want a determination letter from the IRS before filing to be sure.

This article seems to infer that most determination letters related to this circumstance have been approved and you would want to make your case under the "environmental" category. 

http://www.journalofaccountancy.com/issues/2009/no...

@Jered Sturm just thinking outside the box here.  But anyway to work a deal with the developer for you to hold on to the property for the full year?

could you do a 1031 exchange to avoid paying capitol gains now?

Originally posted by @Tim G. :

@Jered Sturm just thinking outside the box here.  But anyway to work a deal with the developer for you to hold on to the property for the full year?

 Aside from the great info @Brandon Hall provided, this is also good advice in an effort to reduce your tax implications if the other exclusions do not fly and I would highly recommend you work out a deal with the developer to make that happen so you have a back up for reduction in tax exposure.

Originally posted by @Tim G. :

@Jered Sturm just thinking outside the box here.  But anyway to work a deal with the developer for you to hold on to the property for the full year?

 That is precisely where I was headed.  Any chance your could sell him an option now which fixes he strike price on the house and he could start developing at the other end of the block and give you an additional 3-4 months?

Was developer able to sign a closing docs with a date 3 months late? Could developer make two payments - 50% this year and 50% next year ?

Thanks for the input everyone Unfortunately @Will Barnard   @Tim G. @Jane A.  the developers did not budge on the close date at ALL in negotiations. I was able to negotiate a substantial  (more then the tax burden from not being 1 year) price increase to accommodate their close date so I guess it worked out. 

Originally posted by @Jered Sturm :

Thanks for the input everyone Unfortunately @Will Barnard   @Tim G. @Jane A.  the developers did not budge on the close date at ALL in negotiations. I was able to negotiate a substantial  (more then the tax burden from not being 1 year) price increase to accommodate their close date so I guess it worked out. 

 I hope so. I also hope that you were properly represented as "substantial" is a very subjective adjective. Depending on the numbers from the opposite side of the table, it may not be. Is the deal closed or still in escrow?

@Will Barnard

 We are closed. Learning now what everyone else around me sold for I did quite well on negotiations. 

In addition to the many items I have to back my partial exclusion case I have convince the developer to sign a letter stating they could and would have developed around me if I would not have sold. If they would have done this they believe my parcel would have drastically dropped in value.   Im hoping this will only strengthen my case if I did get audited. 

@Brandon Hall

They closing agent is going to send me a 1099 for the sale of the home. Does this mean I need to fill out a form explaining my partial exclusion on my return?

@Jered Sturm

You have to report the gain if you received a 1099-S. If you decide to go for the partial exclusion, you will report the gain on Form 8949. 

Hope this helps.

Hi @Brandon Hall !

We're in a similar, but slightly different situation.....we live in a condominium and a developer has approached the association and offered to buy the entire building. We closed on the condo in March of this year and the sale would probably take place on November 1st. 

The association must vote to accept the offer. If the vote is 75% or greater, we are forced to sell or enter a type of arbitration where the purchaser only has to offer fair market value under state law (Illinois). 

But for the vote and forced sale, we would not be selling our home.

I have looked everywhere to find some guidance on this, but can't find anything. Any thoughts on whether this would qualify as unforeseen? 

Thanks so much!

Tyler 

Originally posted by @Brandon Hall:

@Linda Weygant thanks for the mention!

@Jered Sturm I do have key word alerts set up for my name and I appreciate your kind words!

Unfortunately, I take the position that this sale will not qualify for the "unforeseen circumstances" test as the developer buying up the neighborhood improves your financial position. Additionally, "unforeseen circumstances" is the hardest test to qualify for as there is a lot of grey area in the code and rulings (the other two tests are employment and health).

Per Reg. Sec. 1.121-3(e)(1):

In general. A sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. A sale or exchange by reason of unforeseen circumstances (other than a sale or exchange deemed to be by reason of unforeseen circumstances under paragraph (e)(2) or (3) of this section) does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.

The gains will be subject to capital gains tax instead.

Hope this helps!

@Brandon Hall we bought our house 3 bed 2 bath with the knowledge we were pregnant with our 3rd child. 2 boys 1 girl if it matters. I am looking to sell my house now because we are unexpectedly pregnant with our fourth child and looking for a bigger home so each kid can have their own rooms. Waiting to find out the sex of the 4th but if it is a boy then I don't believe 3 kids legally are allowed to share a room. If it is another girl I am not sure if it still constitutes qualifying for the exclusion based off the house just being two small for a family of 6. I deeme the house to the section below. But I am curious if it would fall under the same area as some of the past judgements do. 

Letter ruling 200652041 or 200613009

The home became significantly less suitable as a main home for you and your family for a specific. 

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