By repossessing a personal residence the taxpayer had sold by taking an installment note, the taxpayer ended up losing access to the IRC §121 $500,000 exclusion of gain on the sale of a principal residence in the case of Debough v. Commissioner, 141 TC No. 17, affd CA8, 2015 TNT 168-11, No. 14-3036.

The case deals with the interplay of IRC §121 (the exclusion for the gain on the sale of a qualifying residence) and IRC §1038 (a provision that is meant to offer relief when a taxpayer repossesses real property).  Effectively the Tax Court concluded that IRC §1038’s provisions trump the relief provision of IRC §121 in this fact pattern.

Generally if a taxpayer exchanges a note for property that’s an exchange of assets.  Exchanges, absent special rules, are treated in the same manner as a sale, with the fair value of the asset received being treated as the sale price of the asset sold. 

Under the general rule a taxpayer repossessing real estate would compare the taxpayer’s basis in the installment note with the fair value of the property received, recognizing gain or loss on the exchange subject to any other special tax rules.

Under §1038 is a special rule that applies when a taxpayer repossesses real property in satisfaction of a note that secured the real property.  In that case gain or loss on repossession is ignored, but with a major caveat—the taxpayer must recognize gain to the extent of any cash or other property received as payments on the note prior to the repossession, reduced by any amount previously recognized as taxable gain.  The goal is to put the taxpayer back where he/she was “taxwise” prior to the sale, but giving credit to (and taxing) the cash received since the taxpayer did receive that along with getting back the property.

A special rule is found at IRC §1038(e) that provides if the property in question was the taxpayer’s principal residence and §121 applied to the original sale, if the taxpayer resells the reacquired property within one year then the gain rules do apply generally, but rather the resale is simply treated as part of the original sale of the property.

In the case before the Tax Court, though, the property was not resold within one year of reacquisition (something not terribly surprising in the generally down residential real estate market of 2009, the year in question).  So the question became how the matter should be treated in this case.

The taxpayer argued that they should be able to apply the $500,000 gain exclusion to the §1038 gain calculation and thus only recognize collections in excess of $500,000 as gain (and, in this case, there were such collections).  The taxpayers argue that the existence of §1038(e) indicates Congress was aware of the interplay of the provisions and offered a limited response for that special case so “additional gain” on the second sale could still be excluded.

The IRS disagreed about the import of §1038(e).  To the IRS the existence of this provision agrees Congress was aware that there are two sections here, but the limited application of §1038(e) means that unless that provision is triggered (by disposing of the property within one year after reacquisition) the general rules of §1038 should apply and, being this is not gain on the sale of a residence but rather “§1038 gain” that §121 is not applicable.

The Tax Court sided with the IRS.  The Court noted:

Whatever the reasoning behind the exception, the relief offered by section 1038(e) is clearly limited to those sellers who resell their principal residences within one year of reacquisition. Since petitioner did not resell the property within one year of reacquisition, he is ineligible for the section 1038(e) exception and must recognize gain in accordance with the general rules of section 1038.

The Court notes that, under traditional rules of statutory construction, the existence of a specific exception to a general rule implies that Congress intended to exclude any further exceptions that it did not explicitly provide for.

The Court finds this consistent with the economics of the situation noting:

Petitioner received $505,000 in cash before the reacquisition of his former principal residence. Petitioner has received "money" as defined within section 1038(b) that exceeds gain previously returned as income on the sale of the property during periods before the reacquisition. We see nothing unfair in the Code's taxing petitioner on receipt of this income, as he is actually in a better position than he was before the sale by virtue of having ownership over both the property and $505,000.

The taxpayer, most likely receiving property with a much lower fair value than it had when it was originally sold, might not see the issue the same way.  But, regardless, the taxpayer ends up with a bill for tax due on $505,000 less the gain the taxpayer had previously recognized on the installment sale.

The taxpayer, deciding the result was unfair, appealed the decision of the Tax Court to the Eighth Circuit but found the answer turned out the same.

The appellate opinion notes:

Section 1038(b)(1) requires a taxpayer to recognize gain upon the reacquisition of property to the extent that the amount of money the taxpayer received prior to the reacquisition exceeds the "amount of the gain . . . returned as income" in prior years. 26 U.S.C. § 1038(b)(1) (emphasis added). Put another way, we read § 1038(b) as acknowledging two types of gain upon reacquisition of real property: gain that was "returned as income" -- that is, reported as income on a prior tax return -- and gain that has not yet been "returned as income." On his 2006, 2007, and 2008 tax returns, DeBough reported gain totaling $56,920-i.e., he "returned" $56,920 "as income."

Section 121(a), on the other hand, states that "[g]ross income shall not include gain from the sale . . . [of a] taxpayer's principal residence." 26 U.S.C. § 121(a). "In the case of a husband and wife who make a joint return for the taxable year of the sale . . . of the property," gain of $500,000 can be excluded from gross income. 26 U.S.C. § 121(b). The principal-residence exclusion is, as the name indicates, excluded from income. Having been excluded from income in 2006, the $500,000 principal-residence exclusion cannot be considered gain that was "returned as income" on a prior tax return.

Therefore, the panel agrees with the tax Court and the IRS that the taxpayer must recognize the $505,000 received as cash, less the $56,920 already recognized, as income when he failed to resell the property within one year of reacquiring it.

The Court also noted the taxpayer’s proposed alternative reading would render §1038(e) unnecessary, noting “Section 1038(e) has no ‘operative effect’ if a taxpayer may claim the principal-residence exclusion regardless of whether, upon reacquisition, he resold the property within one year, resold it after more than one year had passed, or never resold the property.” A general rule of statutory interpretation is that an interpretation that renders a provision superfluous is generally to be rejected if an alternative reasonable interpretation exists that does not render any part of the law superfluous. For that reason the panel refused to accept the taxpayer’s argument that since the statute did not specifically state the §121 exclusion did not apply they should be allowed to continue to take advantage of it despite not selling within one year.