The Home Sale Exclusion Rule – How Does it Work When Land is Also Sold?

Overview

Section 121 of the Internal Revenue Code provides for the exclusion of gain that is attributable to the sale of the taxpayer’s principal residence.  The maximum exclusion is $500,000 for taxpayers that are married and file jointly.  It’s one-half of that amount for single filers.  Of course, the IRS just doesn’t give the exclusion away.  The taxpayer has to meet certain requirements.  In addition, the provision only applies to the taxpayer’s “principal residence.” 

But, what if there is a farm sale and the residence is sold with the farm?  In that event, how much (if any) of the farmland and outbuildings can be included with the residence to exclude gain under the provision?  Also, what if the taxpayer uses a part of the residence for business?  How does that impact the exclusion?  What if the farm and residence are sold on an installment basis and the buyer defaults and the seller gets the property back?  What then? 

Excluding gain associated with the sale of the principal residence – it’s the focus of today’s blog post.

Eligibility

The two-year rule.  To be able to claim the I.R.C. §121 exclusion, the taxpayer must have owned the residence for at least two years or more (in the aggregate) during the five years immediately preceding the sale date.  Also, the taxpayer must have occupied and used the home as the taxpayer’s principal residence for at least two years (in the aggregate) of the five years preceding the sale date.  In addition, the taxpayer must not have used the gain exclusion during the immediately preceding two years before the sale. 

Adjacent Land

Treasury regulations address the eligibility of vacant land for the $500,000/$250,000 exclusion. Treas. Reg. § 1.121-1(b)(3).  In general, the sale or exchange of vacant land is not included under the gain exclusion rule applicable to the principal residence unless: (1) the vacant land is adjacent land containing the principal residence; (2) the taxpayer owned and used the vacant land as part of the taxpayer’s principal residence; and (3) the taxpayer engages is a sale or exchange of the principal residence meeting the requirements of I.R.C. §121 either two years before or two years after the date of the sale or exchange of the vacant land.  In addition, the requirements of I.R.C. §121 must be met with respect to the vacant land. 

Note:   It is important that the taxpayer owns the vacant land in the taxpayer’s name rather than via an entity that the taxpayer has an ownership interest in.  See, e.g., Farah v. Comr., T.C. Memo. 2007-369. 

Based on those requirements, land that has been used in farming within the two-year period before the sale won’t be eligible.  If the land is used in farming, it’s not being used as part of the principal residence.  Also, the sale of the principal residence and the adjacent land are treated as a single sale for purposes of the gain limitation amount.  That’s the case even if the sales occur in different years.  In addition, because the separate transactions are treated as a single sale for purposes of applying the rule under I.R.C. §121 that bars use of the provision more frequently than every two years.  Thus, if the principal residence is sold in a later tax year than the qualified adjacent land is sold that is after the filing date (including extensions) for the return that includes the land sale, the gain from the land sale has to be reported as a taxable event.  When the residence is later sold, the taxpayer then can claim the I.R.C. §121 exclusion with respect to the vacant land by filing an amended return.  Procedurally, when calculating the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land.  Treas. Reg. §1.121-1(b)(3)(ii)(C).

Note:   In a situation where a fire destroyed the taxpayer’s principal residence, the IRS determined that I.R.C. §121 was applicable to the sale of the resulting vacant land on which the dwelling had been located.  The gain exclusion provision applied to the gain from the receipt of insurance proceeds for the destruction of the principal residence and also to the sale of the vacant land in the next tax year.  Priv. Ltr. Rul. 201944006 (Jul. 31, 2019).

How much land?  It’s a factual question as to how much land can be included with the principal residence for purposes of I.R.C. §121.  A relevant factor is whether the land has been for personal purposes, such as a garden to grow produce for the taxpayer’s consumption.  Also, if the land is landscaped, that fact supports inclusion with the personal residence.  On the other hand, if the land is used in the taxpayer’s farming business (or contains outbuildings used in the farming business) or otherwise to produce income, inclusion with the residence is not supported.

Business Use of the Residence

If part of the principal residence is used for business purposes, the I.R.C. §121 exclusion does not apply.  At least that’s the rule to the extent any depreciation is claimed.  Also, the exclusion is inapplicable to a portion of the property that is separate from the dwelling unit.  On that separate portion, the problem is that the taxpayer hasn’t satisfied the personal occupancy requirement.  So, in that case, only the gain that is allocated to the residential portion is excludible.  But, no allocation is required is both the residential and business portions of the property are within the dwelling unit, other than to the extent that the gain is attributable to depreciation. 

It might also be possible to trade the home that has an office in it for qualified replacement property and qualify the transaction as a tax-deferred exchange under I.R.C. §1031.  Of course, this can only happen if both the principal residence that is traded away and the replacement property that is received both have at least a portion of the property that is used in the taxpayer’s trade or business or held for investment.  But, legislation enacted in 2004 denies the I.R.C. § 121 exclusion to property acquired in a like-kind exchange within the prior five-year period beginning with the date of property acquisition.  The provision is designed to counter situations where (1) the property is exchanged for residential real property, tax-free, under I.R.C. § 1031; (2) the property is converted to personal use; and (3) a tax-free sale is arranged under I.R.C. § 121.  The provision applies to sales or exchanges after October 22, 2004. Legislation enacted in late 2005 clarifies that the five-year ineligibility period also applies to exchanges by the taxpayer or by any person whose basis in the property is determined by reference to the basis in the hands of the taxpayer (such as by gift)

The Gain Exclusion Rule and Like-Kind Exchange Treatment

However, if like-kind exchange treatment applies to the residence, the homeowner may also be able to benefit from exclusion of gain.  In early 2005, IRS published guidance (Rev. Proc. 2005-14) on coupling the I.R.C. § 121 exclusion with like-kind exchange procedures.  Under that guidance, the IRS said that the I.R.C. §121 exclusion is applied before the I.R.C. §1031 like-kind exchange rules, and that the I.R.C. §121 exclusion cannot apply to gain attributable to depreciation of the residence after May 6, 1997.  But, the I.R.C. §1031 rules may apply to that gain.  Also, the IRS said that when the I.R.C. §1031 rules are applied, any boot or non-like-kind property that is received is taxable only to the extent the boot exceeds the gain excluded under I.R.C. §121.  In addition, when determining basis of the property received in the exchange, any gain that is excluded under I.R.C. §121 on the former property is treated as providing basis to the taxpayer in the replacement property.  The impact of the guidance is that, for farm residences, the amount of the allowable exclusion will more than cover the gain involved. In other situations, the Rev. Proc. may allow deferral of realized gain into replacement property.

In Priv. Ltr. Rul. 201944006 (Jul. 31, 2019), a married couple lived in a home on a property that one of the spouses had purchased before the marriage.  After the marriage, they continued to use the home as their principal residence.  They later moved into a new home and offered the prior residence for rent.  The prior home was rented for both short-term rentals and was also rented to full-time tenants.  The rental use stopped when a fire destroyed the property.  The couple received insurance proceeds for the destroyed residence and sold the land without rebuilding the residence.  In the same transaction, they used the insurance and sale proceeds to acquire two other rental properties, and sought to defer the gain on the sale under I.R.C. §1031 in addition to the use of I.R.C. §121 to exclude the gain associated with the residence. 

The gain on the sale exceeded the amount the couple could exclude under I.R.C. §121.  They satisfied the ownership and use tests of I.R.C. §121.  Thus, the question was whether they could use I.R.C. §1031 to defer the remaining gain to eliminate current tax on the transaction.  The IRS determined that they could because excluding gain under I.R.C. §121 does not preclude the use of I.R.C. §1031 for property that involves an exchange of investment property.  The IRS applied the same reasoning as it had in Rev. Proc. 2005-14, 2005-1 C.B. 528 which also provided the mechanics of recording the transaction.  Under Section 4.02 of Rev. Proc. 2005-14, I.R.C. §121 is applied to the realized gain before I.R.C. §1031 is applied, and the basis of the property received in the exchange is increased by any gain attributable to the relinquished property that is excluded under I.R.C. §121.  

Installment Sale

What if the principal residence and the farmland are sold via an installment sale and the seller claimed the I.R.C. §121 exclusion on the principal residence?  The normal rules would apply and the gain attributable to the principal residence would be excluded up to the applicable limit.  But what if the buyer, after making a few payments, defaults on the contract and the seller gets the property back – including the principal residence on which the gain was previously excluded?   This is not an unlikely possibility given the downturn in the farm economy in recent years which could result in a buyer not having the ability to make the annual payments that the installment contract requires.  This situation occurred in Debough v. Comr., 142 T.C. 297 (2014).  In that case, the taxpayer had purchased a personal residence in 1966 along with 80 acres for $25,000.  He agreed to sell the residence and the land in 2006 for $1.4 million with the purchase price to be paid in installments through 2014.  He reported the gain for the year of sale (computed in accordance with the calculated gross profit percentage) after excluding the gain attributable to the principal residence, and then received another $505,000 in payments that he reported on the installment method.  The buyer defaulted and the seller reacquired the property in 2009.  The reacquisition triggered tax to the taxpayer, but he didn’t report the portion of the gain that was previously excluded under I.R.C. §121.  The IRS disagreed, pointing out that I.R.C. §1038(e) specifies that, with respect to I.R.C. §121, a taxpayer that reacquires property and sells it within one year can treat the subsequent sale as the original sale for I.R.C. §121 purposes.  The taxpayer didn’t do that, so the provision didn’t apply.  That meant that the only way to exclude the gain was to move back into the residence to meet the two-out-of-five-year ownership and use test.  Of course, the taxpayer didn’t want to do that.  The only relief available was that the reacquisition would cause an increase in the basis of the residence to the extent of the gain recognized on repossession which, in turn, would result in less gain on resale.  In 2015, the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court.  Debough v. Shulman, 799 F.3d 1210 (8th Cir. 2015). 

Conclusion

The home sale exclusion rule comes in handy when a principal residence is sold.  But, careful planning is needed when the residence is sold with the farm, when a portion of the residence is used for business purposes, or when the transaction is structured as a deferred exchange or installment sale.