• Taxpayers Not Permitted to Exclude Gain on Sale of Rebuilt Residence that They Never Occupied
  • August 24, 2010
  • Law Firm: Loeb Loeb LLP - Los Angeles Office
  • Section 121 of the Internal Revenue Code permits a married couple to exclude the first $500,000 of gain they recognize upon the sale of their home if they have occupied the home as their principal residence for at least two years out of the five years preceding the sale. In Gates v. Commissioner, decided by the Tax Court on July 1, 2010, the court was called upon to determine whether the taxpayers had sold the same home they had occupied for two years as their residence.

    The Gates used a home previously purchased by Mr. Gates before their marriage as their principal residence for at least two years from August, 1996 to August 1998. At that point, they moved out of the house, demolished it, and constructed a new house on the lot. They never lived in the new house and sold it on April 7, 2000 for $1,100,000, resulting in gain of $591,405. The question before the court was whether they could exclude the first $500,000 of their gain under Section 121. The IRS argued that the house the Gates lived in for two years was not the same house that they sold. They never lived in the new house that they sold. This caused the IRS to take the position that they did not qualify for the gain exclusion of Section 121.

    The court sided with the IRS and ruled that the taxpayer must actually have lived in the particular dwelling that was sold. It is not good enough to sell any structure on the same parcel of real property. This decision will lead to uncertainty in the application of Section 121. It is common for people to substantially remodel their homes. At what point does a remodeling become so extensive that the home is considered a new home for purposes of Section 121, requiring two more years of occupancy before it is sold? Will it make a difference whether you move out or continue to live in the home during the remodeling? Unless there is further clarification, the conservative course would now be to occupy the home for two years after a significant remodeling, if you can. This is especially the case if your remodeling was so extensive that you moved out of the house while the work was being done.