Claire R. McKenzie, Eric R. Pfanenstiel & Katherine Welz Herr, Schiller DuCanto & Fleck LLP, Chicago and Wheaton
312-609-4907 | E-mail Claire R. McKenzie | 630-784-7412 | E-mail Eric R. Pfanenstiel | 630-784-7149 | E-mail Katherine Welz Herr
Below is an excerpt from §8.65 of the upcoming FAMILY LAW: PROPERTY AND FINANCIAL ASPECTS OF DISSOLUTION ACTIONS — 2019 EDITION, available for preorder here.
Tax Planning Rules in Connection with the Family Home
Under the Taxpayer Relief Act of 1997, a homeowner may exclude from income up to $250,000 of gain realized on the sale of his or her principal residence, an exclusion that increases to $500,000 for joint filers. This exclusion applies to only one sale or exchange in every two years, and the individual must have owned and occupied the home as a principal residence for two of the five years preceding the sale. In the dissolution context, there is “tacking” to the time during which a spouse is treated as owning the residence (i.e., “tacking” of the period owned by the first spouse who transferred his or her interest in the residence under Internal Revenue Code §1041 to the other spouse). Further, an individual is treated as using property as that individual’s principal residence during any period of ownership while such individual’s spouse (or former spouse) is granted use of the property under a dissolution or separation instrument. Overall, the foregoing rules — as set out in Code §121 — accord far greater flexibility for dissolution planning than was possible under prior law. 26 U.S.C. §121.
In Gates v. Commissioner, 135 T.C. 1 (2010), all judges on the U.S. Tax Court, sitting en banc, addressed a troublesome issue under Code §121, that issue being whether $500,000 of total gain (aggregating $591,406) was eligible for the §121 exclusion on the sale by the couple of a residence that was a newly constructed dwelling unit built on the foundation of a demolished predecessor dwelling unit, the predecessor being a dwelling in which the taxpayers had resided for a period in excess of the required two years. The issue in Gates stemmed from the fact that the taxpayers had sold their newly constructed successor home before they had moved into it and lived there for two years.
The majority (concurring) and the dissenting opinions in Gates collectively present a detailed summary of predecessor Code provisions (i.e., those pre-1997) relative to rules as to principal residences, as well as a textbook example as to how courts analyze a statutory construction issue under the Code when a key term is not adequately defined in the statute. In particular, §121 does not formally define such terms as “property” and “principal residence”; as a result, the Gates wound up in the U.S. Tax Court.
Unfortunately for the Gates, the Tax Court majority (i.e., nine judges) concluded that §121 entails a requirement that a dwelling unit sold to a third party must be one in which the taxpayer(s) actually resided. Pointing out the lack of clarity the majority’s rationale provides in certain circumstances (e.g., Where is the line of demarcation to be drawn between a “demolished home” and a “remodeled home”?), the five dissenting judges made clear their preference for a rule that would “treat the demolition and reconstruction [cases] no differently from a renovation.” 135 T.C. at 21. However, as a practical matter for planning purposes, any taxpayer focusing on extensive renovation to a principal residence — one that may be followed by a swift sale that could lead to substantial realized gain — should analyze Gates carefully and be guided accordingly.
For more information about tax law, see STATE AND LOCAL TAXATION — 2017 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.