Introduction:

Most readers of this column are at least vaguely aware that Section 121 of the Internal Revenue Code provides an exclusion from income for a hefty portion of the gain a taxpayer might realize on the sale of their principal residence.[i] It allows an exclusion of up to $250,000.00 of gain for a single taxpayer,[ii] and up to $500,000.00 for a married couple filing jointly.[iii]

As with many relief provisions, however, there are conditions, and there are limitations, and there are exceptions to the conditions and limitations.

During the five years immediately preceding the sale, the taxpayer must have owned the property and used it as his “principal” residence for periods aggregating at least two years.[iv] In the case of spouses filing a joint tax return, at least one spouse must meet the ownership requirement, both must meet the “use” requirement, and neither can have excluded gain on the sale of another residence within the preceding two years.[v]

If the couple do not meet all three of these requirements, they might still claim an exclusion on a joint return for the sum of the amounts each could separately have excluded had they not been married, treating each as having owned the property during the period that either owned it.[vi]

 

Nonqualified use

In 2008, Congress amended § 121 to require that a portion of realized gain be allocated to any periods of “nonqualified use” of the property during the taxpayer’s ownership, and to disallow any exclusion from income for that portion of the gain.[vii]  For this determination, periods prior to January 01, 2009 (the effective date of this legislation) are disregarded. The phrase “nonqualified use” is defined as any period during which the property was not the taxpayer’s “principal” residence.[viii] Where the taxpayer has more than one residence, the question which is the “principal” residence is a matter of “facts and circumstances,”[ix] but ordinarily we are considering the residence at which the taxpayer spends more than half the year.

Apart from vacation homes, the most common case of a “nonqualified use” would be one in which the taxpayer has rented out the property. In that circumstance, the taxpayer likely also claimed deductions against rental income for depreciation of the property. (Or could have.) And any recapture of “allowable” depreciation as ordinary income cannot be excluded. This comes off the top, before we start allocating realized gain between “qualified” and “nonqualified” use.[x]

There are a couple of exceptions to the “nonqualified use” rule that are relevant to the recent Tax Court memorandum decision we came here to talk about.

First, if the taxpayer meets the two out of five years “use” requirement, any portion of the five year period occurring after they cease using the property as a principal residence – what  you might think of as the “bridge loan interval” – will not be treated as a “nonqualified” use.

And second, any period of “temporary absence,” not exceeding two years, “due to change of employment, health conditions, or such other unforeseen circumstances as may be specified” in formal guidance from IRS[xi] will not be treated as a “nonqualified” use.

This latter rule, which we will call “the (b)(5)(C)(ii) exception,” is not to be confused with yet another rule, which we will call “the (c)(2)(B) exception,” that provides that if the sale of the residence is itself “by reason of” a “change of employment, health, or unforeseen circumstances,” and the taxpayer does not meet the two out of five years “use” requirement, he may nonetheless exclude a portion of the realized gain,[xii] calculated as a fraction of the otherwise applicable exclusion amount, where the period of his ownership and use during the five years preceding the sale is the numerator and the two year requirement is the denominator.

For example, if a taxpayer had only one year of qualified use during the five years preceding the sale and the sale was forced because of “unforeseen circumstances,” they could still claim 50% of the exclusion amount. But if there had been no qualified use at all during those five years, the taxpayer would be out of luck.

 

The Webert scenario

There is a great deal more in § 121, but the foregoing 800-some-odd words should be enough to get us started with the recent Tax Court memorandum decision in Webert v. Commissioner.[xiii]

The taxpayers, Steven and Catherine Webert, were married in 2004. In February 2005, Catherine bought the property at issue in her separate name for just under $800,000.00. This was a five-bedroom, 3,000 square-foot house on Mercer Island in Washington Lake, near Seattle, Washington. Catherine put down $200,000.00 in cash and took out an adjustable rate mortgage for the balance.

Steven did already own another, much smaller, house in nearby Sammamish, but apparently the couple lived in the Mercer Island house from 2005 through sometime in 2009.

Unfortunately, Catherine was diagnosed with cancer right about the time she bought the Mercer Island house. Almost immediately, she began to incur significant medical expenses, and she became unable to work. She took out a couple or three home equity loans, and ultimately Steven co-signed a $100,000.00 line of credit secured by the house.

The situation became unsustainable, and they needed to cash out. They put the Mercer Island house on the market, and moved into Steven’s house in Sammamish. Unfortunately, the housing market had collapsed in the wake of the 2008 financial crisis, and after at least one sale contract fell through, the Weberts began renting out the house in late 2009.

They reported rental income for most of the next six years. Even when the Mercer Island house stood vacant for months at a time, the Weberts did not use it as their principal residence after 2009. That is, unless Catherine’s absence due to illness was perhaps a continuing qualified use under the (b)(5)(C)(ii) exception.

 

The property finally sold in October 2015 for about $1.1 million. Catherine realized a gain of about $200,000 on the sale.

Pop quiz: were the Weberts eligible to exclude any portion of the gain on this sale?  If so, how much?

 

Opening the can of worms

On their joint tax return for calendar year 2015, the Weberts claimed an exclusion under §121 for the full amount of the realized gain. They filed that tax return late. In the meantime, the Weberts had divorced.

The late filed return for 2015 was accompanied by late filings for each of the preceding five years. The Internal Revenue Service had other concerns about these tax returns, apparently having largely to do with Steven’s reported income and claimed deductions, but these are not detailed in the Tax Court’s memorandum opinion, which deals solely with the Commissioner’s motion for partial summary judgment on the gain exclusion question.

Among other things, Catherine was seeking relief from Steven’s liabilities as an “innocent spouse.” She actually did not oppose the Commissioner’s motion. Steven did.

The Commissioner argued that the Weberts could not exclude any part of the gain because neither of them had used the Mercer Island house as a principal residence during any portion of the five years immediately preceding the sale. Although Steven argued to the contrary, he did not produce any evidence, and of course the tax returns reporting rental income tended to contradict his argument.

Both the taxpayers and the Commissioner seem to have assumed that the (b)(5)C)(ii) exception might still apply to treat at least some portion of the couple’s absence from the Mercer Island property as a qualified use, even after they began renting out the property in 2009. The court suggested this view was mistaken, but invited further briefing on the issue.

In his reply to Steven’s response to the motion, however, the Commissioner took the trouble to say that the separate exception for a sale that was itself triggered by a change in the taxpayer’s health – what we are calling “the (c)(2)(B) exception” – also did not apply, because Catherine’s health was not, he said, a “primary reason” for the sale.

Judge Gustafson, who is hearing the case, felt that this was a new question the taxpayers had not yet been given an opportunity to brief. So he denied the Commissioner’s motion to that extent.

 

Concluding remarks

Since the (c)(2)(B) exception does still require at least some qualified use during the five years preceding the sale, it seems clear that the Weberts will not be able to make a case for that exception, and they will ultimately be denied the exclusion altogether. That is, unless Judge Gustafson can be persuaded to revise his view that the (b)(5)(C)(ii) exception cannot be read to give Catherine a qualified use for any portion of the five years immediately preceding the sale.