The Tax Court held that a married couple could not exclude gain under IRC § 121 from the sale of a house that they had never lived in, built after they had demolished their former residence on the same site. The court held that Congress intended that the exclusion should apply only when the property sold includes the dwelling that has been used as a principal residence for the requisite period.
Section 121 generally permits married taxpayers to exclude up to $500,000 of gain from the sale or exchange of property if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence for a period of, or periods totaling, at least two years. Gain from the separate sale of land adjacent to a principal residence can also qualify for the exclusion if that sale occurs two years before or after the sale of the dwelling.
David Gates purchased an 880-squarefoot home in California in 1984. He married Christine Gates in 1989. The couple wanted to remodel and enlarge the home, but after being informed by an architect of new building codes, the couple in 1999 decided to demolish the old house and build a new one more than double its size. The Gateses never lived in the new house and sold it in 2000 at a gain of $591,406. The couple did not report any of the gain. They had lived in the original house for at least two years out of the five years preceding the sale, and they agreed that $91,406 of gain should have been reported; however, the IRS assessed a tax deficiency based on inclusion of the entire gain.
In the Tax Court, the Gateses argued the term “property” in section 121 includes the land on which a house rests, and if they lived in any dwelling for the requisite period on the land that was sold, section 121 would apply. Section 121 does not define “property,” so the court examined its legislative history and case law. In the committee report on the 1997 law that amended sections 121 and 1034 dealing with the sale of a principal residence, Congress repeatedly used the terms “home” and “house” interchangeably with “principal residence.” The first law passed by Congress dealing with this issue in 1951 referred to property as either “old residence” or “new residence.” Therefore, the court concluded that the property sold must include a structure used as the taxpayer’s principal residence for the requisite period.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
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