Case — Exclusion of Gain on Sale of Residence

Thanks for sharing!

TL Case Summ

THE QUESTION

What’s the definition of a principal residence for purposes of excluding the gain on the sale of the residence from income?

THE DISPUTE

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.

THE LAW

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

For the or for the

THE COURT’S DECISION

Download (PDF, 47KB)

***

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.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

***

Other posts you might enjoy

Decisions — Taxing choices Image source: Free Picture © Semen Barkovskiy Dreamstime Stock Photos   How many options can you consider before you find yourself longing for simplicity? Whatever your answer, part of the desire for less complexity comes from not wanting to make the wrong choice. That's especially true ...
Decisions — Where’s your refund? Image source: By U.S. National Archives and Records Administration, Public domain, via Wikimedia Commons Where's your refund? Possibly helping to reduce the federal budget deficit, if you failed to file a return to get an overpayment back within the applicable time period. That's because the gov...
Case — Fun and games Image source: openclipart.org (public domain image) THE QUESTION Does an organization that offers a recreational activity to achieve a charitable purpose qualify as a charitable organization? THE DISPUTE Taxpayer Says: It operates for charitable purposes because it provides relief for the p...
Case — Carry On THE QUESTION Can an IRA deduction that is disallowed due to active participant status in an employer plan be carried forward and deducted in a future year? THE DISPUTE Taxpayer Says: The 2008 IRA contribution was an “excess contribution” and should be allowable as a deduction in 2010. Intern...
Sorry, wrong answer :(
Right answer!
For the IRS. Legislative history demonstrates Congress intended the term “principal residence” to mean the primary dwelling or house that a taxpayer occupied. To obtain the benefits of the residence gain exclusion, a taxpayer who sells a dwelling must have actually used it as a principal residence.
Posted in Taxing Lessons Case Summaries Tagged with: