Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

The Taxpayer Relief Act of 1997 (1997 act) replaced the rollover and one-time exclusion provisions for sales of personal residences with one "simplified" exclusion amount. A variety of details and gray areas were left open by the 1997 act, leaving many practitioners questioning whether or not the 1997 Act amounted to "simplification." The IRS has now issued final regulations clarifying the operation of these rules under several circumstances that practitioners had identified for the IRS.

Prior Law

Under prior law, taxpayers had two options for avoiding immediate gain on the sale of a personal residence. One choice was a "rollover" of the gain to a new personal residence by reducing the taxpayer's basis in the new residence. The rollover rule only deferred the gain (until the sale of the new residence), and it required that the cost of the new personal residence equal or exceed the sale price of the prior home and that the new home be purchased within two years (before or after) of the sale. The other choice under prior law was a one-time exclusion from income of $125,000 of gain by sellers 55 or over who had owned property and used it as their principal residence for three years or more during the five-year period ending on the date of the sale.

These rules encouraged taxpayers to roll gain over from residence to residence until they were age 55 and eligible for the one-time exclusion of $125,000. Congress felt that this pattern promoted an inefficient use of taxpayers' financial resources by encouraging purchases of more expensive houses in order to avoid tax liability. This was particularly a concern for taxpayers moving from areas with high housing costs to lower-cost areas.

Section 21

The 1997 act eliminated the rollover and one-time exclusion provisions and created a new exclusion from gain rule that is generally available every two years. Code § 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain married taxpayers filing joint returns) of gain realized on the sale or exchange of a principal residence if specific ownership and use requirements are met.

The $250,000 exclusion applies if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating two years or more. The $500,000 exclusion amount is available for spouses filing a joint return for the year of the sale or exchange if either spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse has used the exclusion in the two-year period ending on the date of the sale or exchange. If these requirements are not met, the $250,000 exclusion can still be used on a joint return if one of the spouses meets the ownership and use requirements with respect to the property.

Section 121 also includes an exception to the two-year requirement for sales or exchanges due to the taxpayer's change in place of employment, health, or unforseen circumstances. If these circumstances are met, the taxpayer is allowed a reduced exclusion based on the portion of the two-year period for which the ownership and use requirements were met. This reduced exclusion is available for spouses filing joint returns if either spouse meets the requirements. However, the reduced exclusion on joint returns appears to be a fraction of the $250,000 exclusion amount, because the $500,000 exclusion amount is not available unless both spouses meet the use requirement.

Taxpayers can elect not to have the § 121 exclusion apply. This can be beneficial if a taxpayer meets the ownership and use requirements for two different residences during the preceding five years and expects to sell both residences within a two-year period. Under those circumstances, the taxpayer should reserve the exclusion for the residence with the larger expected gain.

There are also some exceptions to the new exclusion. Not surprisingly, the exclusion is not available to individuals using expatriation to avoid tax. Also, for taxpayers who have rental or business use of their principal residence, the exclusion will not apply to depreciation allowable (and recaptured upon sale) for periods after May 6, 1997.

Final Regulations

On December 23, 2002, the IRS issued final regulations relating to the exclusion of gain from the sale or exchange of a principal residence pursuant to § 121. The final regulations address a variety of issues, and several items of particular interest are outlined and summarized below.

1. Exclusion of Gain from the Sale or Exchange of a Principal Residence

The regulations reiterate the general rule under § 121 that a taxpayer may exclude up to $250,000 ($500,000 for certain joint returns) of gain realized on the sale or exchange of the taxpayer's principal residence if the taxpayer owned and used the property as a principal residence for at least two years during the five-year period ending on the date of the sale or exchange. The regulations specifically address "principal residence" issues and vacant land.

a. Principal residence

The final regulations provide that the residence a taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer's principal residence. However, the regulations do include a non-exclusive list of factors that are relevant in identifying a property as a taxpayer's principal residence. The factors include place of employment, location of family members, address on tax returns, driver's license, auto registration, voter cards, mailing address for bills and correspondence, location of banks, and locations of religious and recreational affiliations. Presumably, these factors and other facts and circumstances could be considered in determining that a property used less than a majority of the year was nevertheless a taxpayer's principal residence for that year.

b. Vacant land

Commentators requested clarification of the circumstances in which vacant land surrounding a residential structure would be treated as part of the residence for purposes of the exclusion. Under § 1034 and former § 121 (pursuant to several IRS rulings and tax cases), a sale of vacant land that did not include a dwelling unit did not qualify as a sale of the taxpayer's residence. However, the sale of vacant land and a replacement residence as part of a series of transactions that all occurred within two years (before or after) the date of the taxpayer's purchase of a replacement residence were treated as one sale.

The final regulations take a similar approach and apply § 121 to a sale or exchange of vacant land owned and used as part of the taxpayer's principal residence if the sale or exchange of the dwelling unit occurs within two years before or after the sale or exchange of the vacant land. The regulations require that the vacant land be adjacent to land containing the dwelling unit and that the sale or exchange of the vacant land otherwise satisfy the requirements of § 121. Only one maximum limitation amount of $250,000 ($500,000 for certain joint returns) applies to the combined sales or exchanges of the vacant land and dwelling unit. The regulations include special rules to deal with sales or exchanges that occur in different taxable years.

2. Use as a Principal Residence

a. Occupancy requirement

Numerous commentators proposed a facts and circumstances test for the use requirement, along with a variety of special exceptions for taxpayer intent, armed services personnel and temporary absences. The final regulations rejected these suggestions, leaving the strict occupancy requirement from the statute in place. Treasury indicates any change in this regard would be inconsistent with the statutory approach under § 121 of aggregating periods of use over a five-year period, particularly since the legislative history provides that "a taxpayer must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange."

b. Property used in part as a principal residence

The IRS and Treasury Department reconsidered certain allocation rules in the proposed regulations and made some adjustments. Under the final regulations, § 121 will not apply to the gain allocable to any portion of property sold or exchanged with respect to which a taxpayer does not satisfy the use requirement if this non-residential portion is separate from the dwelling unit. Additionally, if the depreciation for periods after May 6, 1997 attributable to the non-residential portion of the property exceeds the gain allocable to the non-residential portion of the property, the excess will not reduce the § 121 exclusion applicable to gain allocable to the residential portion of the property. No allocation of gain is required if both the residential and non-residential portions of the property are within the same dwelling unit, but § 121 will not apply to the extent of any post-May 6, 1997 depreciation adjustments. The final regulations provide that the term dwelling unit has the same meaning as in § 280A(f)(1), but does not include appurtenant structures or other property. The regulations also require that the taxpayer use the same method to allocate the basis and the amount realized between the business and residential portions of the property as the taxpayer used to allocate the basis for purposes of depreciation, if applicable.

3. Ownership by Trusts

The final regulations provide that, if a residence is held by a trust, a taxpayer is treated as the owner and the seller of the residence during the period that the taxpayer is treated as the owner of the trust or the portion of the trust that includes the residence under §§ 671 through 679. Similar treatment is provided for certain single-owner entities.

4. Dollar Limitations Applicable to Jointly Owned Property

Responding to requests from several commentators, the final regulations address property owned jointly by unmarried taxpayers. Each unmarried taxpayer who jointly owns a principal residence may be eligible to exclude from gross income up to $250,000 of gain that is attributable to that taxpayer's interest in the property.

5. Reduced Maximum Exclusion

Section 121(c) allows a reduced exclusion amount for taxpayers who have owned or used a principal residence for less than two of the five years preceding the sale or exchange or who have excluded gain from another sale or exchange during the prior two years. Taxpayers may qualify for the reduced maximum exclusion if the sale or exchange is by reason of a change in place of employment, health, or unforeseen circumstances. The final regulations provide guidance regarding the computation of the reduced maximum exclusion. However, because comments and responsive rules were so extensive, new proposed and temporary regulations have been issued addressing circumstances that may qualify as a change in place of employment, health, or unforeseen circumstances.

6. Property of Deceased Spouse

Commentators suggested that the regulations be modified to allow a surviving spouse to exclude up to $500,000 of gain if a marital home is disposed of within one year of the death of the decedent spouse. Because the $500,000 exclusion is only available to spouses who file a joint return and a surviving spouse can only file a joint return with the decedent spouse for the year of the decedent spouse's death, the final regulations do not adopt this suggestion. The regulations also do not address commentators' request for clarification regarding the computation of basis and gain for surviving spouses.

7. Partial Interests

The final regulations allow a taxpayer to exclude gain from the sale or exchange of partial interests (other than interests remaining after the sale or exchange of a remainder interest) in the taxpayer's principal residence if the interest sold or exchanged includes an interest in the dwelling unit. However, the regulations provide that only one maximum limitation amount of $250,000 ($500,000 for certain joint returns) applies to combined sales or exchanges of partial interests. The regulations do have special rules addressing sales or exchanges of partial interests that occur in different taxable years.

8. Special Elections

Commentators asked for clarification regarding the elections under § 121(d)(8) (election to have the exclusion apply to a sale or exchange of a remainder interest in the taxpayer's principal residence) and § 121(f) (election to have the exclusion not apply to a sale or exchange). The final regulations provide that a taxpayer may make or revoke either election at any time before the expiration of a three-year period beginning on the last date prescribed by law (determined without regard to extensions) for the filing of the return for the taxable year in which the sale or exchange occurred.

9. Reporting Sales or Exchanges

In spite of proposals to the contrary, the final regulations confirm that gain excluded under § 121 is not required to be reported, and no IRS form is created for that purpose. Treasury actually indicated that reporting of excluded gain is unnecessary and would be unduly burdensome for taxpayers.

10. Section 121 Exclusion in Individuals' Title 11 Cases

The regulations provide that the bankruptcy estate of an individual in a Chapter 7 or 11 bankruptcy case may use the individual's § 121 exclusion if the individual satisfies the requirements of § 121. Although the effective date for this provision is on or after publication of the final regulations, it does not appear that the IRS will challenge a position taken prior to the effective date that a bankruptcy estate may use the exclusion if the debtor would otherwise satisfy the § 121 requirements.

11. Effective Date

The final regulations apply to sales or exchanges on or after December 24, 2002.

Conclusion

IRS and Treasury have addressed a variety of the concerns voiced by commentators with respect to § 121 and the previously proposed regulations. Of course, the application of § 121 and the now final regulations will continue to develop as courts begin addressing these new provisions.