Tuesday, July 27, 2010

Gain on Sale of House Not Excluded . . . New House Not the Same as Old House

The Federal Tax Code allows a married couple to exclude the first $500,000 of capital gain upon the sale of a home if they have occupied the home as a principal residence for at least two out of five years preceding the sale. But what if the homeowners decide to one day build a new house on the same property, are they still entitled to the capital gain exclusion? Apparently not, according to the IRS. And that is exactly what happened in Gates v. Commissioner of Internal Revenue where the U.S. Tax Court sided with the IRS on July 1, 2010.

Mr. Gates resided in his home for the requisite period of time before he married Mrs. Gates. When they married, they moved out, demolished the old house and built a new one. The problem was that they never lived in the new house after it was built. They sold it eventually for $1.1 million, and realized a gain of $591,405 from the sale.

The IRS ruled that the Gates were not entitled to the capital gain exclusion because they should have lived in the house that was sold in order to be entitled to the exclusion. It is not enough to sell just any structure on the same parcel of real estate.

The problem with the decision and the IRS ruling is that it begs the question: how much renovation, reconstruction or remodeling can you do to your home before the house is considered a "different" structure? Given the recent construction boom of the past few years, the decision will significantly impact thousands of taxpayers.

Until there is further clarification from the IRS or the courts, it may be wise to live in a newly renovated or constructed dwelling for at least another two years before selling . . . if possible.