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September 9, 2015

Case Shows When a Taxpayer Can’t Use Home Sale Tax Exclusion

Assuming the client meets all the requirements of Section 121 and the gain doesn’t exceed the allowable limits, the federal income tax bill is zero. Right? Not always. As a new case handed down by the Eighth Circuit Court illustrates, a taxpayer may ...

Suppose one of your clients sells his or her principal residence and elects to claim the home sale exclusion on a sizeable capital gain. Assuming the client meets all the requirements of Section 121 and the gain doesn’t exceed the allowable limits, the federal income tax bill is zero. And that should be the end of the matter…right?

Not always. As a new case handed down by the Eighth Circuit Court illustrates, a taxpayer may encounter problems by reacquiring the home after a foreclosure. If the home is not resold quickly, the taxpayer could owe tax on the reacquisition, including the amount excluded under Section 121 (DeBough, CA-8, 8/28/15).

First, here’s some background information. If a taxpayer sells a home owned and used as a principal residence for at least two of the previous five years, he or she can elect the home sale exclusion. The exclusion shelters from tax a gain of up to $250,000 for a single filer and $500,000 for a joint filer. It’s one of the biggest tax breaks on the books.

But what happens if a seller repossesses the home through a foreclosure after the buyer defaults on a loan or other contract? Under a corresponding section of the tax code, Section 1038, the seller is restored to his or her position before the sale by ignoring gain or loss upon the repossession. However, if the seller received payments before repossessing the home, he or she is taxed on amounts not previously reported as income. Nevertheless, under an exception to this general rule in Section 1038(e), the seller may avoid any tax liability if the home is then resold within one year .

In the new case, Mr. De Bough agreed to sell his principal residence in 2006 for $1.4 million. The contract required for the $1.4 million to be payable in installments until 2014 when the remaining balance would become due.

DeBough reported a gain of more than $657,000 and excluded the maximum $500,000 from tax under Section 121. For the first three years of the contract, he reported $56,920 of gain. Subsequently, the buyer failed to comply with the terms and DeBough reacquired the property in 2009. He treated the event as a reacquisition of property in full satisfaction of debt under Section 1038. Then he applied the $500,000 home sale exclusion again, but he never resold the property.

The IRS determined that DeBough didn’t qualify for the home sale exclusion because he didn’t meet the requirement for reselling the home within one year under the Section 1038(e) exception. The Tax Court agreed with the IRS, so DeBough appealed to the Eighth Circuit. His main argument: The tax code is “silent” on the issue of whether the home sale exclusion remains available in this situation.

But this taxpayer’s argument fell on deaf ears. Based on legislative history, the Eighth Circuit Court said that it was Congress’ clear intention to require the resale within one year to avoid the tax liability. Otherwise, this provision wouldn’t be necessary. As a result, DeBough forfeited the home exclusion when he repossessed the home.

With so much at stake, it is important for clients to be aware of all the key rules for the Section 121 home sale exclusion, including interaction with other tax code sections.

 

 

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Tags: Income Taxes, Taxes

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