Reacquisition of Principal Residence Triggers Loss of Exclusion

The 8th Circuit Court of Appeals affirmed the opinion of IRS and Tax Court in this case.

On July 11, 2006 Marvin DeBough sold his principal residence on the installment method for $1.4 million.  He reported gain on the sale of 658k, of which 500k was excluded under IRC Section 121.  The remaining 158k of gain was reported on the installment method.  From 2006-2008 he collected 505k in principal payments and reported 56k of this as gain through the installment method.  The buyers failed to comply with the terms of the contract, so Mr. DeBough took the property back during July 2009.

The rules under Section 1038, which control the gain on a repossession/foreclosure, basically require reporting as income the difference between the amount of value (i.e., money) received and the amount already taxed.

The Section 121 exclusion permits a taxpayer to exclude up to $500,000 ($250,000 if single or MFS) of the gain as long as the taxpayer meets the “two out of the last five year” ownership and occupancy conditions.  If the taxpayer did not have enough gain to use the maximum exclusion AND resells the property within one year of the repossession/foreclosure date, the taxpayer can use the rest of the maximum exclusion to offset gain from the resale.  Mr. DeBough did not resell the property within one year of the repossession/foreclosure date.

The issue in the DeBough case is whether, 1) the exclusion amount of 500k claimed on the original sale still applies, or 2) Mr. DeBough has to report income equal to the entire amount received less the 158k already taxed.  IRS and Tax Court said the answer is #2 – Mr. DeBough has to report income equal to the excess of the principal payments received over the amount already taxed.

In his appeal Mr. DeBough stated Section 1038 didn’t apply since he did not resell the property within one year of the repossession/foreclosure date.  He further argued the Code was “silent on the question” of whether the exclusion originally taken was still applicable.  The Court of Appeals, 8th Circuit agreed with IRS and Tax Court – Mr. DeBough owed taxes on the 448k he received in excess of the 56k already taxed.

Marvin DeBough, CA 8 8/28/15, 106 AFTR 2d, 2015-5192


This text has been shared with you courtesy of David & Mary Mellem, EAs & Ashwaubenon Tax Professionals.