Gain exclusion lost upon reacquisition of former principal residence

A repossession of a former principal residence pursuant to default on a contract for deed results in the partial recognition of gain previously excluded under Sec. 121.

The Tax Court held that the portion of a taxpayer’s gain excluded under Sec. 121 was properly recognized when he repossessed his former principal residence, under the general rule of Sec. 1038 regarding reacquisition of real property. The taxpayer did not qualify for the exception of Sec. 1038(e) for principal residences because he did not resell the property within one year after reacquiring it, as that subsection requires.

Facts: In 2006, Marvin Debough sold his principal residence of 40 years and the surrounding 80 acres for $1.4 million on a contract for deed. Under its terms, he would receive installment payments and interest through 2014. On his and his deceased spouse’s 2006 federal income tax return, Debough calculated a total gain of $657,796, excluded $500,000 of it under Sec. 121, and, using the installment sale method, reported a long-term capital gain of $28,178 from the $250,000 cash payment he received that year. He also received principal payments of $250,000 in 2007 and $5,000 in 2008, reporting long-term capital gains of $28,178 and $564, respectively, in those years.

In July 2009, Debough reacquired the property after the buyer defaulted on the contract for deed and reported a 2009 long-term capital gain of $97,153 (the original gain of $157,796 after the Sec. 121 exclusion, minus the sum of the previously recognized gains of $56,920 and repossession costs of $3,723). In 2012, the IRS sent Debough a notice of deficiency based on a recalculated gain of $448,080, determined by subtracting the previously recognized gains of $56,920 from the total cash received of $505,000.

Under the general rule of Sec. 1038(a), no gain or loss is recognized as the result of a taxpayer’s repossession of real property in satisfaction of a debt that secures the property. However, if the taxpayer has previously received cash or other property with respect to the sale of the property, Sec. 1038(b) requires the recognition of gain equal to the amount of cash and fair market value of other property received, minus the amount of previously recognized gain. The amount of recognized gain is limited to the property’s selling price minus its adjusted basis, less any previously recognized gain and repossession costs.

Sec. 1038(e) permits nonrecognition of gain when a taxpayer repossesses a former principal residence previously sold at a gain that was excluded under Sec. 121 and the property is resold within one year of the date of the property’s reacquisition.

Issues: Debough argued in the Tax Court that gain previously excluded under Sec. 121 should never be recognized when a former principal residence is repossessed, because no specific provision requires its recognition. The IRS argued that Debough was subject to the general rule of Sec. 1038 and that he did not qualify for the exception of Sec. 1038(e) because he did not resell the property within the required one-year period.

Holding: The Tax Court agreed with the IRS and refused to create another exception involving a repossessed principal residence where Congress had not specifically written such an exception into the statute. The court also stated that recognition of gain in this case was consistent with the intent of Sec. 1038 and the economics of the transaction because Debough retained the $505,000 in cash he had received and his former residence after the repossession. According to the court, its holding was also in accord with basic federal income tax principles because the payments Debough received were “clearly an accession to wealth” that Sec. 1038 required, in the absence of a specific statutory exclusion, to be included in gross income.

– Debough, 142 T.C. No. 17 (2014)

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