Taxpayers not entitled to exclude gain from sale of principal residence.

• Author: Aponte, Stephen E.

In a recent decision, the Tax Court ruled that a couple who sold a house they had never lived in could not take advantage of the Sec. 121 exclusion. That in itself is not surprising. The twist in this case was that the couple had lived in a house on that same property for years, but then tore it down and built a new house on the property that they never lived in. Although they claimed they should still be entitled to the exclusion, the Tax Court disagreed.

History of the Exclusion of Gain on Sale of a Principal Residence

Before 1951, no exclusion for gain on a principal residence existed. If a taxpayer had any gain on a sale of a residence, it was taxed as a capital gain. Realizing the hardship taxpayers could face by having to pay tax on the gain of their principal residence, especially if circumstances out of their control forced them to sell, Congress decided to provide relief. Former Sec. 112(n)(l) was enacted in 1951 to provide that relief. It provided that no gain on the sale of a principal residence would be recognized if the taxpayer purchased a new residence at a price at least equal to the selling price of the old residence within a specified time. Any gain not recognized would be deferred and used to calculate any gain on the new residence when it was ultimately sold. Sec. 112(n)(1) eventually became Sec. 1034 when the Internal Revenue Code was rewritten in 1954.

In 1964, Sec. 121 was enacted, which allowed an individual to exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) had attained the age of 55 before the sale and (2) had owned the property and used it as a principal residence for three or more of the five years immediately preceding the sale. Unlike Sec. 1034, Sec. 121 was a permanent exclusion, not a deferral of income. However, taxpayers were allowed to take advantage of this exclusion only once.

Now that both rules were in place, it was possible for most taxpayers to never have to pay capital gains tax on a sale of their principal residence. While they were under 55 years of age they could sell their home and roll the gain over into the next home that they purchased. When they were retired and ready to downsize or possibly not purchase a new home at all, they could use the one-time exclusion under Sec. 121 to exclude the gain entirely.

In 1997, Congress enacted the Taxpayer Relief Act of 1997, P.L. 105-34, which repealed Sec. 1034 and amended Sec. 121...