Gain recognized from repossession of principal residence

The repossession of a taxpayer's former principal residence more than one year after its sale triggered the recognition of previously excluded gain.
By Charles J. Reichert, CPA

Affirming a Tax Court decision, the Eighth Circuit held that a taxpayer who repossessed his former principal residence after the buyer defaulted had to recognize gain equal to the excess of the cash received over the previously recognized gain. According to the court, the taxpayer could not use an exception to the gain recognition rule because he did not resell the property within the one-year period prescribed in the exception.

Facts: In 2006, Marvin DeBough sold his principal residence in Minnesota under an installment contract, resulting in a gain of $657,796. He excluded $500,000 of the gain under Sec. 121 and deferred the remaining gain of $157,796 to the years that the installment payments would be received. In 2006, 2007, and 2008, DeBough received payments totaling $505,000, reporting gains totaling $56,920 on his federal income tax returns for those years. DeBough repossessed the property in 2009 after the buyer defaulted, kept the $505,000, and incurred costs of $3,723 due to the repossession. He initially reported long-term capital gain of $97,153 ($657,796 gain, minus the $500,000 principal residence exclusion, minus $56,920 of recognized gain, minus costs of $3,723) on his 2009 federal return but later filed an amended return reporting no gain.

In 2012, the IRS assessed a deficiency after determining that DeBough's 2009 gain should have been $448,080 ($505,000 cash received, minus $56,920 of previously recognized gain). He petitioned the Tax Court for relief, lost the case (see previous coverage, "Tax Matters: Gain Exclusion Lost Upon Reacquisition of Former Principal Residence," JofA, Aug. 2014, page 73), and then appealed the decision to the Eighth Circuit.

Issues: The general rule of Sec. 1038(a) permits nonrecognition of gain by a seller when the seller reacquires real property as debt satisfaction after the buyer defaults on the loan. However, Sec. 1038(b) requires the recognition of gain to the extent that the amount of any money and the fair market value of other property received exceeds the amount of the gain previously returned as income. Under Sec. 1038(e), if a repossessed principal residence is resold within one year after the date of reacquisition, Sec. 1038(b) does not apply, and the resale of the residence is treated as part of the original sale transaction, permitting the continued use of the principal residence gain exclusion. DeBough argued that Sec. 1038 does not specifically address whether the principal residence exclusion can be used when the reacquired principal residence is not resold within one year and that this silence permits the use of the exclusion regardless of when the property was resold. Furthermore, he argued, Sec. 1038 has no provision that requires the recognition of gain previously excluded from a sale of a principal residence.

Holding: The appeals court held that Sec. 1038(b) categorizes the gain from the repossession of real property as either income reported on a prior year's tax return (returned as income) or as income not yet reported (returned) and that DeBough's $500,000 of previously excluded gain could not be treated as gain that was returned as income.

The court rejected DeBough's argument that the principal residence exclusion could be used regardless of when the property was resold because, under that interpretation, Sec. 1038(e) would not be needed. Thus, if it adopted DeBough's interpretation, the court would be violating the settled rule of statutory construction that a court must, if possible, construe a statute to give every word of the statute some operative effect. The court further found that the legislative history of Sec. 1038 also supports the interpretation that the principal residence exclusion should apply only to taxpayers who resell that property within a reasonable period (one year) after repossession, and all other repossessions of real property, including principal residences, are subject to the gain recognition provision of Sec. 1038(b).

  • DeBough, No. 14-3036 (8th Cir. 8/28/15), aff'g 142 T.C. 297 (2014)

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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