Lessons from the Tax Court: A key home-sale-exclusion rule — Business Management Daily: Free Reports on Human Resources, Employment Law, Office Management, Office Communication, Office Technology and Small Business Tax Business Management Daily

Lessons from the Tax Court: A key home-sale-exclusion rule

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The home sale gain exclusion is a king-size tax break that’s available when you sell your castle. Briefly stated, if you’ve owned and used the home as your principal residence for at least two out of the five years before the sale, you can exclude from federal income tax up to $250,000 of gain or $500,000 if you’re a married joint filer.

However, if you repossess the home after providing seller financing and then foreclose on the property to get it back, you could run into some unexpected tax trouble. Reason: Under the tax code section governing this occurrence, you may lose the right to the gain exclusion that you claimed when the property was sold.

Section 1038 restores you to your position before you sold the home. If you receive payments prior to the reacquisition, you’re taxed on amounts not previously reported as income. However, under a special exception in Section 1038, you can shelter these amounts with your gain exclusion if you resell the home within one year after repossessing it.

New decision: In 2006, the taxpayer agreed to sell his principal residence for $1.4 million, payable in installments for eight years through 2014. He reported a gain of more than $657,000 and claimed the maximum $500,000 gain exclusion.

During the first three years the contract was in effect, the taxpayer received installment principal payments of $505,000 and reported almost $57,000 of taxable gain. But then the buyer defaulted and the taxpayer repossessed the home in 2009. He treated the event as a reacquisition of property under Section 1038 and applied the $500,000 home sale exclusion again. The catch: He never resold the property.

The IRS said that the taxpayer didn’t qualify for the Section 1038 exception because he didn’t sell the property within the one-year window of opportunity. The taxpayer argued that the tax law was essentially silent as to whether the home sale exclusion was still available. But the Tax Court sided with the IRS.

Tax outcome: Now the 8th Circuit Court has affirmed the Tax Court decision. The legislative intent of Congress was clear that the home has to be resold within one year. So the taxpayer forfeited the home sale gain exclusion when he repossessed the home and failed to resell it within the one-year window. Therefore, he owed tax on the entire $505,000 of installment principal payments that were received before the repossession. (DeBough, CA-8, 8/28/15)

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