A U.S. District Court found that the issues surrounding the taxpayer’s sale of a property that the taxpayer argued qualified for the principal residence exclusion under IRC §121 were not clear enough to grant summary judgement to either the taxpayer or the IRS on the issue of qualification for the exclusion in the case of United States v. Forte, et al.[1]

The opinion described the situation as follows:

The Fortes purchased their home on Windsong Lane (Windsong Home) in 2000 and lived there until 2005. ... In June 2003, the Fortes purchased a lot on Snow Forest Cove with the intent to build a home. The Fortes obtained a loan and began constructing a home (Snow Forest Home) in September 2004. The Fortes sold the Windsong Home in September 2005. The Fortes did not get paid the full contractual amount from the buyer of the Windsong Home Specifically, the Fortes were unable to fully collect on seller finance notes in connection with the Windsong Home sale.[2]

The Snow Forest home, whose disposition would lead to this case, was occupied in 2005.  The facts related to that home were described as follows:

During 2005, the Fortes were experiencing financial stress. The Fortes moved into the Snow Forest Home in December 2005. On or about December 21, 2005, the Fortes purchased the lot adjacent to their home (Lot 3) for $435,000 with the intent to retain a scenic view from their newly constructed Snow Forest Home.

When the Fortes moved into the Snow Forest Home, they had a loan with a high interest rate. They could not refinance the loan due to their bad credit, so they entered into an agreement whereby a “friend of a friend” (Edvik) helped refinance the loan by borrowing in his name. In January 2006, the Fortes executed a warranty deed conveying title to the Snow Forest Home to Edvik, which was recorded. A trust deed naming Edvik as Trustor and the Fortes as beneficiaries was also recorded. Edvik obtained a loan for $1.4 million. Edvik kept $20,000 of the proceeds, and the remainder was used to pay off the Fortes’ loans. The Fortes made the mortgage payments on the new loan. In April 2006, the Fortes also executed a warranty deed for Lot 3 in favor of Edvik.

In February 2007, Edvik signed a quitclaim deed conveying title of the Snow Forest Home to the Fortes. By May 2007, the loan on the Snow Forest Home in Edvik’s name was in default. In August 2007, the Fortes transferred title to the Snow Forest Home to an LLC they owned. It is disputed if and to what extent the Fortes’ financial situation was worsening in the fall of 2007. But it is undisputed that the Fortes sold the Snow Forest Home and Lot 3 for $2.7 million and moved out in September 2007.[3]

The problem is that the taxpayers had not used the home as their principal residence for two years prior to sale, as required under the general rule of IRC §121(a) which reads:

(a)Exclusion

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.[4]

However, IRC §121(c) allows for a prorated exclusion to be available if the taxpayer meets the requirements.  As the opinion explains:

Both motions ask the court to determine whether the Fortes are entitled to exclude from their income gain from the 2007 sale of the Snow Forest Home. 26 U.S.C. § 121(a) provides that “[g]ross income shall not include gain from the sale or exchange or property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 or more years.” It is undisputed that the Fortes did not own and use the Snow Forest Home for a period of two or more years, so they do not qualify for the full exclusion provided by statute.

However, the Fortes may be entitled to a partial exclusion for the period they did own and use the Snow Forest home if they sold the home due to “unforeseen circumstances.” Unforeseen circumstances means that “the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.” A sale “is deemed to be by reason of unforeseen circumstances . . . if any of the events specified . . . occur during the period of the taxpayer’s ownership and use of the residence as the taxpayer’s principal residence. Examples of “unforeseen circumstances include: (1) “involuntary conversion of the residence,” (2) “natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence,” (3) death of a qualified individual, (4) “cessation of employment as a result of which the qualified individual is eligible for unemployment compensation,” (5) “change in employment or self-employment that results in the taxpayer’s inability to pay housing costs,” (6) legal separation or divorce, and (7) “multiple births resulting from the same pregnancy.”[5]

The taxpayers argued that unforeseen circumstances required the sale of the Snow Forest home—their failure to collect the balance due on the Windsong Lane created in a financial situation that forced the taxpayers to sell their home.

The IRS argued that this was not the cause—their financial problems existed at the time they bought the Snow Forest Home and thus were fully foreseeable.

Plaintiff argues that the Fortes cannot rely on the “unforeseen circumstances” provision because when the Fortes moved into the Snow Forest Home, they “were aware of the precarious financial position they were in.” Plaintiff claims that the Fortes further exacerbated their financial difficulties by purchasing Lot 3 the month they moved into the Snow Forest Home.[6]

The IRS argued the case was like that in Chiarito v. Commissioner, T.C. Summary Opinion 2010-149.

In Chiarito, the court determined the taxpayers were not entitled to exclude from their income a gain resulting from the sale of a residence. The taxpayers owned a catering business and purchased a home with the intent to build a second residence on the property which would have an industrial kitchen for their catering business. However, the home was subject to certain regulations that prevented the taxpayers from building the second residence with the industrial kitchen. In reviewing whether the taxpayers could properly exclude the gain from their income, the court made multiple determinations beyond the fact that the taxpayers knew of their financial difficulties. For instance, the court determined that (1) that the taxpayers knew they had a need for an industrial kitchen over one year before purchasing the new home, (2) they were “well aware” of the financial losses the restaurant had sustained in the previous three years, (3) they learned of their inability to build a second residence on the property after they sold the previous home, and (4) there was evidence the sale of the home was attributed to their preference for the other home, all precluding their ability to exclude the gain from their gross income based on “unforeseen circumstances.” In short, the court made multiple fact findings that went beyond general financial difficulty.

Plaintiff’s argument is that because the Fortes “were aware of their financial difficulties” and made those difficulties worse by purchasing Lot 3, they cannot claim it was unforeseeable they would sell the home prior to living in it for two years.[7]

However, the Court noted that, as a Summary Opinion, the ruling was not binding on the Court and, as well, the Forte’s situation was distinguishable from Chiarito.

However, beyond addressing that the Fortes were in financial trouble, Plaintiff does not address how the Fortes could reasonably have anticipated that they would not receive the full sale price of the Windsong Home prior to moving into the Snow Forest Home. There remains a genuine dispute of material fact as to whether the Fortes could reasonably have anticipated that they would not collect the remaining seller finance notes and that this would further exacerbate the Fortes’ financial problems, forcing them to sell the Snow Forest Home in under two years.[8]

But it’s not clear that the Fortes were unaware of the pending default on the Windsong Home when they acquired the Snow Forest Home:

The Fortes argue that it was unforeseeable that they would be defrauded and not receive the full sale proceeds from the buyers of the Windsong Home. They contend that they suffered a “devastating financial blow” after moving into the Snow Forest Home and “that they were victims of a financial crime.”

It is undisputed that the Fortes were already experiencing financial problems in 2005 prior to moving into the Snow Forest Home. But it is disputed when they realized they would not be able to collect the remaining $695,000 in holdbacks from the buyers of the Windsong Home. Mr. Forte’s testimony alludes to trying to collect money from the buyers, but the record does not allow the court to conclude as a matter of law that the Fortes did or did not realize the full extent of the fraud against them until after they moved into the Snow Forest Home in December 2005.[9]

Thus, the Court refused to find, as the IRS requested, that there were no unforeseen circumstances that would qualify the sale for partial exclusion.  But the Court also refused to find that the situation did involve such unforeseen circumstances as the taxpayers wished.  Rather, the Court found that there was a reasonable dispute over the facts that makes the case one that cannot be satisfied via summary judgment—rather, the matter needs to go to trial.

[1] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/court-refuses-to-find-income-on-sale-of-homes-should/76p47 (retrieved June 27, 2021)

[2] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[3] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[4] IRC §121(a)

[5] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[6] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[7] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[8] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021

[9] United States v. R. John Forte et al., US DC UT, Case No. 2:18-cv-00200, June 21, 2021