IRS May Not Let You Exclude Gains from Selling A Home

Under federal tax laws, homeowners are generally entitled to exclude some of the gains from the sale or exchange of their home if the property has been owned and used as their principal residence for periods totaling two or more years over the five-year period before the sale. IRC §121.

Aside from the various limitations, federal law allows married couples to exclude up to $500,000 in gain and non-married individuals to exclude up to $250,000 in gains from the sale of a qualifying principal residence.

The United States Tax Court, in Marvine E. Debough v. Commissioner of Internal Revenue , 14 2 T.C. No . 17, recently addressed whether an individual who sold his primary residence under an installment sale, and excluded $500,000 in capital gains, was later required to recognize the gains he previously excluded when the buyer defaulted on the note and the seller reacquired the property.

In Marvine v. C.I.R., a homeowner sold his principal residence for $1.4M under an installment agreement. The buyers made $505,000 in payments before defaulting on the note, and the seller reacquired the property in full satisfaction of indebtedness secured by the home. The seller did not recognize the $505,000 in payments he received from the buyer before he reacquired the property, and thus, the IRS assessed the seller income taxes for these payments.

The primary issue examined by the U.S. Tax Court in Marvine is whether the seller must recognize gain he previously exclude from the sale under IRC §121 when he reacquires the property and the property is not resold within one year.

In Marvine, the Seller was forced to recognize gain when he reacquired the property in full satisfaction of the defaulted note to the extent of the $505,000 in payments he received before reacquiring the property. The Marvine Court's rationale was "Section 1038(b) requires recognition of gain where a seller receives 'money' or 'other property' before reacquisition [because he] occupies an improved position after reacquisition." Absent the payments the seller received, "he actually is in no better position than he was before he made the sale." Here, the Seller was in a better position than he was before the sale by virtue of having ownership over both the real property and the $505,000 in payments he received from the buyers. Thus, the seller was required to recognize the $505,000 as income. [1]

If you sell your primary residence under an installment sale, and you later reacquire the real property because the buyer defaults on the note, you may consider reselling your property within one year of the date you repossess the property to avoid paying additional taxes on the payments you received from the original buyer.

For questions about the tax consequences from selling your real estate involving an installment sale, or if you have been contacted by the IRS or California Franchise Tax Board regarding your prior real estate sale, contact our San Diego tax lawyer.

[1] IRC §1038 computes gain when a seller repossesses real property to satisfy a defaulted debt that is secured by the real property. Section 1038, however, is intended to remedy situations where taxpayers are forced to recognize gain (based on the property's then fair market value) when they repossess real property and to restore the seller to his position before the sale of the property by ignoring gain or loss upon repossession. The seller will be taxed on any payments the seller received from the buyer under the installment sale before the repossession "to the extent that these amounts have not previously been reported as income." IRC §1038. Special rules apply where the home is resold within one year of the reacquisition.


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