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Saturday, September 05, 2015

No Section 121 Gain Exclusion When Seller of Residence Obtains it Back in Foreclosure

Marvin sold his principal residence for $1.4 million on an installment basis. He reported current gain of $657,796, and excluded $500,000 of that gain from income under Code Section 121 as a sale of a principal residence. The remaining $157,796 of gain was reported on the installment basis. After the sale, Marvin reported $56,920 of gain from cash installment payments received.

The buyer defaulted on his debt and Marvin foreclosed and took the property back. He recognized the remaining $97,153 in long-term capital gains, per the reacquisition of real property rules of Section 1038. Marvin did not resell the residence within a year of his reacquisition.

The IRS asserted that the original $500,000 Section 121 exclusion could not be used to offset gain on the sale and reaquisition, and thus applying the rules of Section 1038 Marvin had gain of $448,080 at the time of the foreclosure and reacquisition. Marvin argued that just because he foreclosed on the property does not mean that the initial $500,000 gain exclusion should not be available to him for purposes of the Section 1038 gain computation.

The Tax Court agreed with the IRS. It noted that Congress did put a special rule in Section 1038(e) that provides if a principal residence is reaquired, and then is resold within 1 year thereafter, the original Section 121 exclusion will continue to apply. Since Marvin did not resell within a year, he could not use this provision. The Tax Court reasoned that if the original Section 121 exclusion applied in a Section 1038 computation of gain for persons that did not resell within 1 year, then there would be no need for Section 1038(e) and it would be a meaningless Code provision. Thus, to give effect to Congress putting Section 1038(e) in the Code, Congress must have recognized that for situations when there is no resale within a year, that Section 121 would not apply.

DeBough, 106 AFTR 2d ¶2015-5192 (CA8 8/28/2015)

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