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Seller Who Reacquired Principal Residence Must Recognize Previously Excluded Gain. (Parker Tax Publishing May 30, 2014)

While cases dealing with the exclusion of gain on the sale of a principal residence under Code Sec. 121 are not uncommon, cases dealing with the reacquisition of property under Code Sec. 1038 are relatively rare. Code Sec. 1038 provides rules for computing gain when a seller repossesses real property in satisfaction of a debt secured by that real property. It generally restores the seller to his position before the sale of the property by ignoring gain or loss upon repossession. However, if the seller has received money and other property as payments before the repossession, Code Sec. 1038 taxes the seller on gain attributable to these payments to the extent the amounts were not previously reported as income. On May 19, 2014, the Tax Court handed down a decision involving a unique issue the interaction of Code Sec. 121 and Code Sec. 1038.

In Debough v. Comm'r, 142 T.C. No. 17 (5/19/14), the taxpayer sold his principal residence in an installment sale and excluded, under Code Sec. 121, $500,000 in gain on the sale. Three years later, the buyers defaulted and the taxpayer reacquired the property. The IRS determined that, under Code Sec. 1038, the taxpayer was taxable on all the gain previously excluded from income, including the $500,000 excluded under Code Sec. 121. While there is an exception in Code Sec. 1038(e) to recognizing income on the reacquisition of a personal residence, that exception applies only if the reacquired property is resold within one year. The taxpayer argued that Code Sec. 121 takes precedence over Code Sec. 1038 and, thus, he was entitled to exclude the $500,000 from the gain reportable under Code Sec. 1038. The Tax Court disagreed, holding that the petitioner was required to include the $500,000 in income.


Marvin Debough purchased his home in 1966 for $25,000. In 2006, he agreed to sell the property for $1,400,000. The contract provided that Marvin would receive $250,000 immediately and then receive the balance in annual and semi-annual payments. The buyer's debt was secured by the residence. On his tax return for that year, Marvin and his deceased wife excluded $500,000 of gain under Code Sec. 121. Marvin reported installment sale gain for 2006 of $28,178. In 2007 and 2008, Marvin reported taxable gain of $28,178 and $564, respectively.

In 2009, the buyer defaulted, and Marvin reacquired the property. On his tax return for 2009, Marvin treated the reacquisition as a reacquisition of property in full satisfaction of debt under Code Sec. 1038 and recognized approximately $97,000 in long-term capital gain.

The IRS determined that Marvin was required to recognize approximately $448,000 in long-term capital gain on the sale and reacquisition. This was calculated by subtracting the gain Marvin reported for 2006 through 2008 from the total $505,000 in cash Marvin had received over those same years.

Taxpayer and IRS Arguments

While Marvin and the IRS agreed that Code Sec. 1038(e) did not apply in Marvin's situation, they disagreed about the significance of the provision. The IRS argued that Code Sec. 1038(e) confirms that Congress was aware of the interplay between Code Sec. 1038 and Code Sec. 121 and drafted Code Sec. 1038(e) as a limited response thereto; the absence of a more generous provision regarding the overlap of Code Sec. 1038 and Code Sec. 121, the IRS argued, confirmed that Congress intended for taxpayers in Marvin's situation to be taxed under the general rules of Code Sec. 1038. As a result, because Marvin did not meet the requirements for special treatment under Code Sec. 1038(e), the IRS said he was governed by the general rule under Code Sec. 1038(b) requiring him to recognize gain upon repossession of the property to the extent of money and other property received before repossession.

Marvin countered that if Congress had intended to completely nullify the Code Sec. 121 exclusion upon reacquisition of a taxpayer's principal residence, it would have drafted a provision explicitly so stating.

Tax Court's Analysis

The Tax Court sided with the IRS, saying that by its terms, Marvin's sale of his principal residence and subsequent reacquisition in satisfaction of indebtedness secured by the property fell squarely within the rules of Code Sec. 1038. The only inquiry left, the court said, was whether Marvin had to recognize gain previously excluded by reason of Code Sec. 121.

The court stated two important conclusions regarding Code Sec. 121: (1) Code Sec. 1038(e) expressly contemplates the sale and subsequent reacquisition of a seller's principal residence, and; (2) other than Code Sec. 1038(e), Code Sec. 1038 does not contain any provision that would allow a taxpayer to exclude Code Sec. 121 gain resulting from a sale and subsequent reacquisition of a principal residence. The fact that Code Sec. 1038(e) is titled "Principal residences" indicated to the court that Congress foresaw the potential interaction of Code Sec. 1038 and Code Sec. 121. Thus, the court stated, Code Sec. 1038(e) operates as an exception to the general rule of Code Sec. 1038 when the subject property is the seller's principal residence. Sellers fulfilling the requirements of Code Sec. 1038(e) by reselling the principal residence within one year are essentially allowed to collapse the initial sale and subsequent resale into one transaction.

The court observed that there is no indication in the legislative history as to why Congress limited the exception to sellers who resell property within one year of reacquisition. Nonetheless, Code Sec. 1038(e) is clearly limited to those sellers who resell their principal residences within one year of reacquisition. Since Marvin did not resell the property within one year of reacquisition, the court concluded that he was ineligible for the Code Sec. 1038(e) exception and thus had to recognize gain in accordance with the general rules of Code Sec. 1038. (Staff Editor Parker Tax Publishing)

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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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