What’s the definition of a principal residence for purposes of excluding the gain on the sale of the residence from income?
Taxpayer Says: $500,000 of the capital gain from the sale of the home is excludable from gross income under the home sale exclusion rules.
Internal Revenue Service Says: The property was not a principal residence. The entire gain should be included in income.
From Internal Revenue Code Section 61(a): Gross income means all income from whatever source derived, unless excluded by law.
From Internal Revenue Code Section 61(a)(3): Generally, gain realized on the sale of property is included in a taxpayer’s income.
From Internal Revenue Code Section 121(a): Allows a taxpayer to exclude from income gain on the sale or exchange of property if the taxpayer has owned and used such property as his or her principal residence for at least two of the five years immediately preceding the sale.
THE CAUSE OF THE DISPUTE
Under current federal income tax law, when you’re married and file a joint return, you can exclude up to $500,000 of the gain on the sale of your principal residence. The exclusion generally applies when you own and use the home as your principal residence for two or more years during the five years before the sale, as long as either you or your spouse meets the ownership requirement, both of you meet the use requirement, and neither of you claimed an exclusion during the two year period before the sale.
One reason disputes arise over what’s excludable is because the Internal Revenue code does not define “property” or “principal residence.”
In this case, the taxpayer owned a home that had been used as a principal residence for more than two years (meeting the tax code’s use requirement for exclusion of gain). The taxpayer wanted to remodel the home. However, due to restrictive building and permit requirements, the home was instead demolished and a new one built on the same site.
The taxpayer never lived in the newly constructed home, and it was sold the year after construction was complete (in 2000). None of the gain on the sale was included in the taxpayer’s 2000 tax return. The taxpayer believed building a new home in place of the old one, on the same site as the old one, meant the new home qualified for the same exclusion as the former home when the “property” was sold.
The IRS contends the term “property” in relation to the home exclusion rules applies to a “dwelling”, and to obtain the exclusion, the taxpayer would have had to live in the new home for two of five years prior to the sale. Because the taxpayer did not live in the newly constructed home at all, the IRS says the entire gain should have been included on the 2000 income tax return.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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