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Taxpayer Can't Use Principal-Residence Exclusion to Reduce Gain from Reacquiring Home.

(Parker Tax Publishing September 15, 2015)

A taxpayer cannot use the principal-residence exclusion to exclude from income amounts received as liquidating damages on the reacquisition of a principal residence. DeBough v. Comm'r, 2015 PTC 303 (8th Cir. 2015).

Background

In 1966, Marvin DeBough purchased a home and surrounding 80 acres of mixed-use land in Minnesota for $25,000. In 2006, DeBough sold the property for $1.4 million pursuant to an installment contract. The buyers' indebtedness was secured by the property. Because the property was his principal residence, DeBough excluded $500,000 of gain from income on his 2006 tax return pursuant to Code Sec. 121 (i.e., the principal-residence exclusion). This left taxable income of almost $158,000 on the sale of the property. DeBough reported this income as installment sale income, beginning in 2006. For 2006, 2007, and 2008, DeBough received $505,000 from the buyers and reported $56,920 as taxable installment sale income during those years.

In 2009, the buyers defaulted and DeBough reacquired the property. DeBough kept the $505,000 he had previously received from the buyers as liquidated damages. On his 2009 tax return, DeBough treated this event as a reacquisition of property in full satisfaction of indebtedness under Code Sec. 1038. In calculating his realized gain on the reacquisition, DeBough again applied the $500,000 principal-residence exclusion and thus reduced the amount reported as long-term capital gains related to the reacquisition. DeBough did not resell the property.

In 2012, citing Code Sec. 1038, the IRS determined DeBough had underreported $448,080 in long-term capital gain for 2009 by applying the principal-residence exclusion to his gain calculation. DeBough objected and took his case to the Tax Court.

Tax Court's Opinion

Under Code Sec. 1038(a), if a sale of real property gives rise to indebtedness to the seller which is secured by the real property sold, and the seller reacquires the property in partial or full satisfaction of such indebtedness, then, except as provided in Code Sec. 1038(b) and Code Sec. 1038(d), no gain or loss results to the seller from such reacquisition, and no debt becomes worthless or partially worthless as a result of such reacquisition. Under Code Sec. 1038(b), in the case of a reacquisition of real property to which Code Sec. 1038(a) applies, gain results from such reacquisition to the extent that the amount of money and the fair market value of other property (other than obligations of the purchaser) received, before such reacquisition, with respect to the sale of such property, exceeds the amount of the gain on the sale of such property returned as income for periods before such reacquisition.

There is a limited exception to the general rule for calculating gain when reacquired property was originally sold as the taxpayer's principal residence. Under Code Sec. 1038(e), if a taxpayer reacquires property that was his principal residence, but then resells that property within one year, the taxpayer can continue to apply the principal-residence exclusion when calculating taxable gain.

The Tax Court agreed with the IRS and held that, under Code Sec. 1038, DeBough was not entitled to the principal-residence exclusion because he had not resold the property within one year. As a result, the general rules applicable to reacquisitions of real property as outlined in Code Sec. 1038(b), the court said, acted to override the principal-residence exclusion, and the prior status of the property as a principal residence was no longer relevant for tax purposes. DeBough appealed to the Eighth Circuit.

Eighth Circuit's Analysis

Before the Eighth Circuit, DeBough argued the Tax Court's interpretation of Code Sec. 1038 was contrary to the intent of Congress and produced an unduly harsh result. DeBough agreed that, because he did not resell the property within a year of reacquisition, Code Sec. 1038(e) did not apply. However, he contended that the Tax Code was silent on the question of whether the principal-residence exclusion nevertheless remained available even when a reacquired principal residence is not resold within one year. There is nothing in Code Sec. 1038, he argued, that requires a taxpayer to recognize gain.

Noting that this was a case of first impression requiring it to interpret the relationship between Code Sec. 121 and Code Sec. 1038, the Eighth Circuit affirmed the Tax Court and held that DeBough was not entitled to use the principal-residence exclusion to reduce his reacquisition gain. Under Code Sec. 1038, the court said, a taxpayer may disregard gain associated with the reacquisition of property, except to the extent that the taxpayer received money from the sale of the property before the reacquisition that is more than "the amount of gain on the sale" that was "returned as income" in any tax period before the reacquisition. In the instant case, the court observed, the parties agreed that DeBough received $505,000 from the sale of the property before reacquiring the property, and claimed $56,920 in gain on the tax returns filed before reacquiring the property.

The Eight Circuit said that it read Code Sec. 1038(b) as acknowledging two types of gain upon the reacquisition of real property: gain that was "returned as income" (that is, reported as income on a prior tax return) and gain that had not yet been "returned as income." On his 2006, 2007, and 2008 tax returns, the court noted, DeBough reported gain totaling $56,920; i.e., he "returned" $56,920 "as income." On the other hand, the court stated, Code Sec. 121(a) states that gross income does not include gain from the sale of a taxpayer's principal residence and, in the case of a joint return, gain of $500,000 can be excluded from gross income. The principal-residence exclusion is thus excluded from income. According to the court, having been excluded from income in 2006, the $500,000 principal-residence exclusion could not be considered gain that was "returned as income" on a prior tax return.

The court then addressed DeBough's argument that the Tax Code was silent on the question of whether the principal-residence exclusion nevertheless remained available even when a reacquired principal residence is not resold within one year. The court said that if DeBough was right, then the Code Sec. 1038(e) exception would be completely unnecessary. Noting that it is a settled rule of statutory construction that a court must, if possible, construe a statute to give every word some operative effect, the Eighth Circuit declined to render this part of a statute entirely superfluous.

For a discussion of the rules relating to reacquisitions of real property, see Parker Tax ¶114,550. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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