INTEROFFICE MEMORANDUM

 

 

TO:                  Professor

 

FROM:            Student

 

DATE:             September 17, 1999

 

RE:                   Bakers and Summers & Outtak: Sales of residences and treatment of the gain

 

 

STATEMENT OF FACTS:

 

            Based on the facts, our clients, two separate couples, face similar issues regarding the sales of their respective residences and the treatment of the resulting gain.  First, John and Alice Baker sold their Florida residence at the end of last year, soon after John’s death.  The married couple owned the house a “relatively short time.”  They apparently bought the house for about $600,000 and sold it for $1.2 million.  They had been spending an increasing amount of time in this Florida home in order to establish Florida residency.  Additionally, for two (2) of the past three (3) years, they paid the Florida intangibles tax, failed to pay their New York income tax, and possessed Florida licenses.

 

            Second, Diane Summers and Dottie Outtak had lived together in their Everglades home for many years.  They sold it this year and made an $800,000 profit.  They owned the house “equal[ly].”

 

ISSUES PRESENTED:

 

A.                 Is the sale of the Bakers’ residence eligible for the amended “principal” residence exclusion (non-recognition provision) under Internal Revenue Code section 121?

 

B.                 If so, is the house includible in John’s estate, and can Alice file a joint return with his estate?

 

C.                 Since Diane and Dottie possessed equal ownership interests in their residence, will they each qualify for the section 121 exclusion?

 

DISCUSSION:

 

In general, the principal residence exclusion, controlled by section 121 (which was significantly expanded due to the Taxpayer Relief Act of 1997), provides that $250,000 of gain ($500,000 for certain married couples filing jointly) will not be recognized upon the sale of a “principal” residence.  See generally Gummer v. United States, 40 Fed. Cl. 812 (1998); JACOB MERTENS, JR., 3 LAW OF FEDERAL INCOME TAXATION § 20:15 (Supp. 1999); R. Arnold Handler, Acquisition, Financing, Refinancing and Sale or Exchange of Residence; Moving Expenses, 594-1st Tax Mgmt. Portfolio (BNA), at A-18+ (1999).

 

First, no age requirement exists under the principal residence exclusion (whereas former section 121 imposed an age requirement).  Second, the exclusion’s residence requirement, which is often separated into “ownership” and “use” tests (or requirements), provides that the taxpayer(s) must own and use the property as a “principal” residence for two (2) of the last five (5) years preceding the sale (instead of the former three (3) year requirement).  I.R.C. § 121(a).  Basically, for spouses filing jointly to obtain the $500,000 principal residence exclusion, only one spouse must satisfy the ownership test, but both spouses must meet the use test, i.e., use of the residence as their “principal” one (defined more broadly under Gummer, supra).  I.R.C. § 121(b)(2).  Third, the taxpayer(s) may use the principal residence exclusion every two (2) years.  I.R.C. § 121(b)(3).  Other and special rules apply, some of which will be discussed below as appropriate.  See I.R.C. §§ 121(c) et seq.

 

A.        Sale of the Bakers’ Residence

 

            Some other rules apply to the Bakers.  To take advantage of the higher $500,000 principal residence exclusion, spouses must file a joint return for the year that the sale occurs.  I.R.C. § 121(d)(1).  Also, to satisfy the ownership test under the residence requirement, a surviving spouse may include the period that the deceased spouse owned and used the residence.  I.R.C. § 121(d)(2).  Finally, regarding the use test under the residence requirement, a taxpayer apparently does not necessarily need to occupy the home physically as a principal residence for the entire two years.  See Gummer, supra (holding occupancy of eighteen months (18), inter alia, as sufficient for use under the old (and probably the amended) principal residence exclusion); Comment, ‘Use’ of Principal Residence Does Not Require Occupancy, 61 TAX’N FOR ACCT. 60 (1998) (citing two articles from the same journal that generally explain the amended principal residence exclusion).  Rather, courts will determine whether the taxpayer “used” the property as a “principal” residence under a “‘facts and circumstances’ analysis,” including consideration of the taxpayer’s good faith in such usage.  Gummer, supra, at 819.

 

            In applying the principal residence exclusion to the Bakers, Alice can arguably file a joint return with John’s estate.  See, e.g., Rev. Rul. 87-104 (holding that, under the former law, a surviving spouse need not be joined in the “maximum” principal residence exclusion election to avoid a sale’s gain).  The residence requirement may pose problems for the Bakers, but, under Gummer, they can qualify for the joint exclusion relatively easily.  Only one of them must own the residence for the specified period, which Alice could do despite John’s death.  However, both spouses must meet the use test for the specified period to take advantage of the maximum exclusion of $500,000.  Based on the facts, it appears that Alice and John clearly intended to use the Florida residence as their principal one for at least two (2) years, especially since they paid Florida’s intangibles tax and failed to pay New York’s income tax.  The facts do not specify how long the Bakers had actually owned and used the Florida residence, but the Gummer court eliminated a strict use test in favor of a facts-and-circumstances test, with particular emphasis on the taxpayer’s good faith.  More facts are needed to determine if the Bakers will definitely qualify for the principal residence exclusion; however, given their two-year payment of Florida taxes and maintenance of licenses, the joint exclusion seems inevitable.

 

However, if they do not qualify for the full joint exclusion, Alice has other options.  Initially, she may want to pursue one of the special rules that allows prorated application of the principal residence exclusion in certain justifiably-motivated circumstances -- even though the requirements of section 121 have not been met; these circumstances include employment changes, health, or “unforeseen circumstances.”  See I.R.C. § 121(c)(2); Handler, supra, at A-19.  Alice might be able to establish an employment change for John since they wanted to change their residency from New York to Florida, or even a health change since he died so suddenly after the sale.  Then they could possibly still use most of the full $500,000 exclusion.  Otherwise, she will want to use her own principal residence exclusion of $250,000 if they cannot jointly satisfy the principal residence exclusion, e.g., if, due to John’s death, they cannot meet the two-year use requirement due to John’s death and the special prorated exclusion rule does not apply.

 

B.         Inclusion of the Bakers’ Residence in John’s Estate

 

            Section 2040(b) includes half of a jointly-owned, married spouse’s residence in the decedent’s gross estate.  Since the sale of the Bakers’ residence did not occur until after John’s death (even though the sales contract on the residence occurred beforehand), Alice and John’s estate will technically split the gain produced by the sale: $1.2 million (amount realized) - $600,000 (aggregate basis) = $600,000 aggregate gain, with $300,000 of gain going to each taxpayer, namely Alice and John’s estate.  If the principal residence exclusion applies jointly, as it seemingly will, then $500,000 of the gain will be excluded and each taxpayer will recognize only $50,000 of the gain.  If the exclusion does not apply jointly, at least Alice will exclude her realized gain up to $250,000 and recognize $50,000, and maybe a prorated exclusion will apply to John’s estate.

 

            Unfortunately, John’s share of the undivided interest in the residence does not receive a “stepped-up” basis under Code section 1014 for purposes of the post-death sale, even though it passed through John’s estate, because the property represents income in respect of a decedent (IRD).  See I.R.C. §§ 1014(c) (basis of property acquired from a decedent) & 691 (IRD).  Therefore, John’s estate calculates the gain as John would if he were living (as outlined above).

 

C.        Sale of Diane’s and Dottie’s Residence

 

            Additional special rules apply to Diane’s and Dottie’s situation.  Generally, before the 1997 amendment, an unmarried individual who held a residence as a joint tenant or a tenant in common could utilize the principal residence exclusion as any other taxpayer; each joint owner was treated separately, or as an individual co-owner, for purposes of applying the former principal residence exclusion.  See Rev. Ruls. 67-234 and 67-235.  “Presumably, these same principles should govern for purposes of present § 121.”  Robert T. Danforth, Taxation of Jointly Owned Property, 823-1st Tax. Mgmt. Portfolio (BNA), at A-56 (1998).

 

            Consequently, Diane and Dottie should each be allowed to exclude up to $250,000 of gain from the sale of their jointly-owned principal residence, provided that they satisfy the section 121 requirements -- as they seem to do -- and regardless of exactly how they owned the joint property (as survivors or in common).  After their respective exclusions, each will recognize $150,000 of the aggregate $300,000 of remaining gain from the sales profit.

 

CONCLUSIONS:

 

            The principal residence exclusion, or section 121 as amended, and the Gummer case establish the rules for excluding or not recognizing gain from the sale of a “principal” residence.  These rules probably allow both of our clients to exclude $500,000 of gain from the respective sales of their principal residences, because both apparently satisfy the amended section 121 requirements (jointly for the Bakers and separately as joint owners for Diane and Dottie) listed above.  The Bakers might not have owned and used their residence for the required term; if they have not, they must either pursue an exception (special rule) or Alice must use her own exclusion and allow John’s estate to recognize its full half of the gain.  Diane and Dottie will likely encounter no problems in using their respective exclusions as joint owners or tenants.

 

RESEARCH METHODS:

 

            First (and due mainly to Hurricane Floyd), I researched this issue at home using MARVIN A. CHIRELSTEIN, FEDERAL INCOME TAXATION (8th ed.) and the Tax Analysts CD-ROM that we purchased in class.  I found the old principal residence exclusion explained in CHIRELSTEIN’s superb book, but it lacked any analysis of the amended law.  However, the Tax Analysts CD contained the new Code section, an explanation in FEDERAL INCOME TAX BY BAEDEKER, and three key Revenue Rulings on section 121.  Second, I went to the law library to expand my research.  I utilized BNA’s Tax Management Portfolios and obtained excellent explanations in number 594 of the Income Series and a summary in number 823 of the Estates, Gifts, and Trusts Series.  Then I researched the issue by using RIA’s and CCH’s tax reporters and found the Gummer case and other citations in both resources.  Finally, I concluded my research by using the computer, namely two citators, Lexis’ Shepard’s and Westlaw’s Keycite, and by performing searches on Westlaw and Findlaw for any other authority on the issue.  I also used the BNA Tax Management Portfolios on the Internet.  In all of my computer research, I found two small articles that explained Gummer.  As before, the traditional research tools provided everything that I needed.