Remodel or rebuild? How the decision could affect the Sec. 121 exclusion.

• Author: Lash, Craig

A recent Tax Court decision forces practitioners to reexamine the types of questions they ask a client during tax planning or their annual tax interview if the client has sold his or her personal residence. Gates, 135 T.C. No. 1 (2010), turned on what may be a debatable point regarding the applicability of Sec. 121.

With regard to the sale of a home, the typical tax organizer will ask for basic information, such as the date the home was sold, acquisition date, selling price, original cost, cost of improvements, and any selling expenses. Questions about residence will most likely be included, such as whether the taxpayer personally occupied the home for at least two of the five years preceding the sale. A copy of the closing statement is also generally requested.

Because of the nature of the transaction and the potential tax impact, a practitioner may receive a phone call from his or her clients before they actually sell the home, as they most likely will be anxious to know how the sale will affect their tax return. Asking additional questions at this time could prove to be extremely beneficial, particularly if the clients have made significant improvements or renovations to their home.

If clients report that they have sold their home, they have owned the home for at least two years during the five years ending on the date of the sale, the home has been their principal residence since the date they purchased it, and they have not excluded from income any gain on the sale of property in the last two years, the practitioner may think it would be safe to assume that they qualify for the exclusion of gain from sale of principal residence under Sec. 121. However, this may not be the case.

Background on Gates

Before examining why this may not always be the correct assumption, it would be helpful to review the Gates decision. The taxpayer purchased a property that included a residence for $150,000 in 1984. In 1989, the taxpayer married. In 1996, the couple wanted to enlarge and remodel the original house, but due to stricter building and permit restrictions since the house was originally constructed, they chose to demolish the original house and in 1999 constructed a new three-bedroom house on the same property. In 2000, the taxpayers sold the new house, in which they never resided, for $1,100,000. The sale resulted in a $591,406 gain to the taxpayers. The couple did not report any gain from the sale of the property as income on their 2000 tax...