Taxpayer denied exclusion for gain on the sale of a principal residence.

• Author: Beavers, James A.

The Tax Court held that taxpayers who demolished a home they had lived in for more than two years, built a new home on the same lot, and then sold the new home without ever living in it were not entitled to exclude the gain from the sale from income under Sec. 121.

Background

In December 1984, David Gates purchased property in Santa Barbara, California, for $150,000. The property included an 880-square-foot two-story building with a studio on the second level and living quarters on the first level.

In August 1989, Gates married his wife, Christina, and they lived in the original house. In 1996, they decided to enlarge and remodel the original house and hired an architect to draw up plans. The architect advised them that more stringent building and permit restrictions had been enacted since the original house was built, although it is unclear if this made enlarging the home impossible or merely economically impracticable.

Subsequently, the Gateses demolished the original house and constructed a new three-bedroom house on the property. The new house complied with the building and permit requirements existing in 1999. However, the couple never resided in the new house. On April 7, 2000, they sold the new house for $1,100,000, resulting in a $591,406 gain. At the time of the sale, the Gateses had lived in the original house for a period of at least two years during the preceding five-year period.

On their late-filed return for 2000, the Gateses did not report any of the $591,406 capital gain generated from the sale of the property as income. On audit, they agreed that $91,406 of the gain should have been included in their gross income for 2000, but they asserted that the remaining gain of $500,000 was excludible from their income under Sec. 121. In 2005, the IRS sent the Gateses a notice of deficiency for 2000 that increased their income by $500,000. The IRS asserted that they had failed to establish that any of the gain on the sale of the property was excludible under Sec. 121. In response, the Gateses petitioned the Tax Court, seeking a redetermination of the deficiency.

Sec. 121

Sec. 121 provides the rules for the exclusion from income of gain from the sale of property that a taxpayer or taxpayers have used as a principal residence. Sec. 121(a) specifies:

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by...