Residence Sale - Technical Analysis

Section 80.3. ROLLOVER OF GAIN ON SALE OF PRINCIPAL RESIDENCE: PRE-1997 ACT RULES

CAUTION: Effective generally for sale or exchanges occurring after May 6, 1997, the Taxpayer Relief Act of 1997 (1997 Act) repealed the rule set forth in pre-1997 Act Code Section 1034 that provided for the rollover of gain on the sale or exchange of a principal residence. For sales or exchanges generally occurring after May 6, 1997, taxpayers may exclude gain resulting from the sale or exchange of a principal residence from their gross income, subject to certain dollar and other limitations <15> Note, however, that the 1997 Act contained transition rules such that a taxpayer may still qualify for pre-1997 Act treatment with respect to the sale or exchange of the taxpayer’s principal residence (see Section 80.2(n)

for a discussion of these transition rules) . For those taxpayers subject to the transition rules, a discussion of the pre-1997 Act Code Section 1034 rules is set forth below. For those taxpayers who are not subject to the transition rules, the following discussion is for historical purposes only.

Under pre-1997 Act Code Section 1034, if a taxpayer realized a gain on the sale of the taxpayer’s principal residence, gain was not recognized if the taxpayer met the following requirements:

(1) The residence that was sold or exchanged was owned by the taxpayer and was the taxpayer’s principal residence;

(2) the new property was purchased, constructed, or acquired by exchange, and was used as the taxpayer’s principal residence; and

(3) the new principal residence was acquired and used as a principal residence within a period beginning two years before and ending two years after the sale of the old residence. <16>

Under pre-1997 Act Code Section 1034, if an amount equal to or greater than the adjusted sales price of the old residence was invested in a new residence, none of the gain realized from the sale was recognized. If, however, an amount less than the adjusted sales price was so invested, gain was recognized to the extent that the adjusted sales price of the old residence exceeded the cost of the new residence. Of course, if there was no investment in a new residence, pre-1997 Act Code Section 1034 did not apply. If any gain was not recognized under pre-1997 Act Code Section 1034, a corresponding reduction had to be made in the cost basis of the taxpayer’s new principal residence.

(a) PRINCIPAL RESIDENCE DEFINED

Pre-1997 Act Code Section 1034 applied only to the sale of property used by the taxpayer as his principal residence. <17> Whether the property was used by the taxpayer as a residence and as a principal residence (in the case of a taxpayer using more than one property as a residence) depended

-1-

on all the facts and circumstances, including the good faith of the taxpayer. <18> For purposes of pre-1997 Act Code Section 1034, property that qualified as a principal residence included a mobile home, <19> a houseboat, a house trailer, or stock held by a tenant-stockholder in a cooperative housing corporation. <20> Property that did not qualify as a principal residence included personal property (such as furniture, radios, or appliances) that, in accordance with the applicable local law, was not a fixture. Reg. Section 1.1034-1(c) (3) (i)

The taxpayer had to have a legal interest in the property sold or exchanged in order for the sale to qualify under pre-1997 Act Code Section 1034. The person who shared the benefits and burdens of ownership, rather than the person who held mere legal title, held the legal interest. <21> For example, a taxpayer residing in a retirement home project that furnished the taxpayer with living quarters and personal care but did not give him any legal interest in the property was not considered a residence in which the taxpayer had a legal interest for purposes of pre-1997 Act Code Section 1034. Rev. Rul. 60-135, 1960-1 C.B. 298.

If the taxpayer’s child had title to the residence, or an estate or a trust owned the property, the non-recognition provisions of pre-1997 Act Code Section 1034 generally were not available because the trust or estate was normally considered the taxpayer. <22> If the trust was a grantor trust, the sale or exchange of such residence qualified for the non-recognition provisions of pre-1997 Act Code Section 1034 if the residence were used as such by the beneficiary who was also the grantor of the trust. Rev. Rul. 66-159, 1966-1 C.B. 162. However, if the residence was used by any other beneficiary, it did not qualify for non-recognition treatment under pre-1997 Act Code Section 1034. Rev. Rul. 54-583, 1954-2 C.B. 158.

If the taxpayer owned and resided in only one residence, it was not difficult to determine that the residence was the taxpayer’s principal residence. <23> However, it was more difficult to make such a determination when the taxpayer owned and occupied two or more residences, both of which were used on a regular basis during the taxable year.

When a taxpayer alternated between two residences, the property the taxpayer occupied the majority of the time ordinarily was considered the taxpayer’s principal residence. For example, in Rev. Rul. 77-298, 1977-2 C.B. 308, the IRS ruled that the Washington house of a Congressman was his principal residence when he lived in the house for eight years, even though he retained ownership of a residence in his home district and used it occasionally when he visited his district. The same conclusion was reached in Friedman v, Commissioner, T.C. Memo. 1982-178, where the taxpayers rented an apartment in New York City and owned a house in Nassau County, since the taxpayers lived in the New York City apartment during the school year, and all correspondence indicated that they used the New York City address as their principal residence. In determining the taxpayer’s principal residence, the Tax Court also has relied on automobile and boat registrations, the taxpayer’s principal place of work, and declarations of residence in deeds. <24>

-2-

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Although it may have been possible for the taxpayer’s principal residence to shift from one residence to another, a taxpayer could not defer the recognition of gain under pre-1997 Act Code Section 1034 on the sale of two residences, both of which were used as a principal residence, by purchasing one new principal residence. Rev. Rul. 77-371, 1977-2 C.B.

308. In this ruling, the taxpayer owned two residences, one of which he used as a principal residence and the other he held as rental property. The taxpayer sold his principal residence at a gain and then moved into the property that he had formerly held for rental. The taxpayer used the second property as his principal residence until he purchased a third residence, which he then used as a principal residence. Later, the second residence was sold at a gain. Although the timing of these transactions satisfied the requirements of pre-1997 Act Code Section 1034, the IRS ruled that the taxpayer had to recognize gain on the sale of the rental property. Note that the taxpayer did not recognize gain on the sale of the first residence, since the cost of the third property purchased was greater than the adjusted sales price of the first residence.

In Rev. Rul. 56-420, 1956-2 C.B. 519, the IRS defined the term "residence" to include property on which the dwelling that the taxpayer actually resided in was located. However, the land alone was not a residence. Thus, a sale of a portion of the property that did not include the house in which the taxpayer resided was not ordinarily considered to be a sale of the taxpayer’s principal residence. <25>

The separate sale of the taxpayer’s house situated on one parcel of land and the sale of a contiguous parcel later in the same year were both treated as the sale of the taxpayer’s principal residence. In Rev. Rul. 76-541, 1976-2 C.B. 246, the taxpayer owned and resided in a house situated on an undivided ten-acre parcel of land. The entire parcel was used as part of the taxpayer’s principal residence. In early 1975, the taxpayer sold the house and three acres of land immediately surrounding the house. The boundaries of the three acres were established by survey, but the seven-acre portion of the original parcel was not divided. The taxpayer also attempted, unsuccessfully, to sell a part of the seven-acre portion along with the three acres.

A few weeks after the sale, the taxpayer began construction of a house on the remaining seven-acre portion to be used as his new principal residence. The house was completed and occupied by the taxpayer in late 1976. Before the end of 1975, the taxpayer sold two acres of the seven-acre parcel to another purchaser. At no time was any portion of the ten acres held by the taxpayer for investment or for use in a trade or business.

The IRS allowed the taxpayer to apply the non-recognition provisions of pre-1997 Act Code Section 1034 to the gain realized from the sale of the three-acre parcel of land containing the taxpayer’s house and also to the gain realized from the separate sale of the two-acre parcel of land. The IRS allowed the two-acre portion to be included as part of the taxpayer’s old principal residence despite the fact that the taxpayer constructed and occupied a new principal residence on the adjacent five acres. In so

-3-

ruling, the IRS distinguished Rev. Rul. 56-420, 1956-2 C.B. 519, in which the IRS denied the benefits of pre-1997 Act Code Section 1034 to the sale of a portion of a city lot on which a taxpayer’s house was located since the property sold did not include the taxpayer’s dwelling and the taxpayer did not purchase a new house, but, rather, continued to reside in the old house. <26>

(b) RENTAL OF VACANT PRINCIPAL RESIDENCE

Although the property sold had to be the taxpayer’s principal residence at the time it was sold, there was no requirement in pre-1997 Act Code Section 1034 that the taxpayer actually occupy the old residence at the time of the sale. <27> However, the property’s status as a principal residence was more uncertain if the taxpayer was not occupying it at the time of sale.

In some circumstances, property not used by the taxpayer as a residence when sold may have lost its status as the old principal residence. For example, a taxpayer who vacated his residence for an extended period was likely to have been considered to have abandoned it as a principal residence, particularly if the taxpayer had been renting it at a substantial profit, with the result that pre-1997 Act Code Section 1034 usually did not apply. However, even in these situations, a taxpayer may have been able to bring a sale within the terms of pre-1997 Act Code Section 1034 by showing that the taxpayer intended to return to the principal residence, but a change of circumstances or plans occurred shortly before the sale, or that market exigencies were responsible for the taxpayer’s failure to sell the principal residence.

The cases that addressed the rental of the old residence generally had three different factual patterns:

(1) The taxpayer moved out of the principal residence with no intent to return;

(2) the taxpayer moved out of the principal residence with an intent to return; or

(3) the taxpayer moved out of the principal residence but was delayed in selling the principal residence due to market exigencies.

The case law relating to each of these fact patterns is discussed below.

In general, if a taxpayer moved out of his principal residence with no intent to return, the sale of the residence several years later did not qualify for pre-1997 Act Code Section 1034 treatment. For example, in Stolk v. Commissioner, 40 T.C. 345 (1963), aff’d per curiam, 326 F.2d 760 (2d Cir. 1964), the taxpayer vacated his home in 1950. In May or June 1953, the taxpayer removed all furnishings in the house with the intention of not living there again or making any further use of the property. The house remained vacant until July 1955. <28> The court found

-4-

that the taxpayer had abandoned the property as a residence at least two years before its sale, thereby disqualifying the property as one used by the taxpayer as his principal residence. Therefore, the court held that the non-recognition provisions of pre-1997 Act Code Section 1034 did not apply. According to the court, the reason the taxpayer had left the home vacant for so long was to wait until he had found a suitable replacement residence such that he would be eligible for the non-recognition treatment under pre-1997 Act Code Section 1034.

The second line of cases relating to taxpayers who rent their principal residence involve taxpayers who moved out of the residence with the intent to return to the home in the next few years but then change their plans after several years and sell the residence. Two Tax Court decisions have allowed non-recognition treatment under these circumstances.

In Trisko v. Commissioner, 29 T.C. 515 (1957), acq., 1959-1 C.B. 5, the taxpayer was assigned a temporary position in Europe in 1948. While there, he leased his residence in Maryland for one year, primarily to keep the house maintained in good condition. On returning to the United States in 1955, the taxpayer was offered a position in Washington, D.C. The taxpayer attempted to regain immediate occupancy of his house, but was unable to because of federal rent control regulations and a lease obligation. After selling the first home and purchasing a second home, the court held that the old house had continued to be the taxpayer’s principal residence, even though he had not lived there for years and he had deducted certain expenses attributable to its rental. Note that the court limited its decision to the facts of the particular case.

In Barry v. Commissioner, T.C. Memo. 1971-179, the taxpayer was a career officer in the United States Army. In 1955, he purchased a home in Annapolis, Maryland. He occupied this home for several years and intended to occupy it after his retirement. In 1960, the taxpayer and his family were sent to Germany, where they lived in government housing, and then were sent to Denver, Colorado, in 1962, where they lived in government housing until his retirement in 1965. While away from Maryland, the taxpayer did not offer his home for sale and turned down several unsolicited offers. At all times the taxpayer intended to return to his home in Maryland. However, immediately before he retired from the military, the taxpayer decided to accept a civilian position in Denver. The taxpayer then sold his home in Maryland. The court allowed the non-recognition of gain on the sale of the home because it found that the taxpayer had at all times intended to return to his home and that the decision to remain in Denver was a last-minute change of plans. Therefore, the home in Maryland remained his principal residence until the sale, and he was eligible for the non-recognition provisions of pre-1997 Act Code Section 1034.

OBSERVATION: In both Trisko and Barry, the taxpayers had left their residences to pursue temporary employment. In Trisko, the foreign service assignment was limited to four years; Barry involved a temporary military assignment. Thus, temporary assignments supported the taxpayers’ arguments that they had no intent to abandon their

-5-

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

residence when they moved out.

In Rev. Rul. 78-146, 1978-1 C.B. 260, the taxpayer’s employer assigned him to another city for a two-year period. At the time of the assignment, the taxpayer owned a home. The taxpayer purchased a second home in the new city because he was unable to find satisfactory rental accommodations. Upon completion of this two-year period, the taxpayer sold the second home. On returning to the first city, the taxpayer learned that the high school near the first home that his children would have attended had been closed, and the new one was at an unacceptable distance. The taxpayer then sold his first home and bought a third home closer to the new high school. The IRS ruled that the first home was the taxpayer’s principal residence for purposes of pre-1997 Act Code Section 1034 because the taxpayer was to be reassigned to the first city at the end of the two-year period, and he intended to return to and reoccupy the first residence at all times during the two-year period.

In general, when a taxpayer moved out of his principal residence with no intent to return, the taxpayer was not entitled to non-recognition treatment under pre-1997 Act Code Section 1034 upon the sale of the residence. However, when there were delays in selling the property due to market exigencies, the general rule may not have applied. For example, in Clapham v. Commissioner, 63 T.C. 505 (1975), acq., 1979-2 C.B. 1, the taxpayer was transferred to an office in another city. The taxpayer had no intentions of returning to his old residence. For a period of three years, the taxpayer attempted to sell his home and had, on a few occasions, leased the property on a short-term basis (less than one year), only because of financial circumstances. In holding that the ultimate sale of the residence qualified for pre-1997 Act Code Section 1034 treatment, the court found that the rentals were necessitated by the exigencies of the real estate market, were ancillary to sales efforts, and arose from the taxpayer’s use of his old residence as his principal residence.

Similarly, in Bolaris v. Commissioner, 776 F.2d 1428 (9th Cir. 1985), the taxpayer vacated his home and tried to sell it. Three months after moving out, the taxpayer rented the home on a month-to-month basis for financial reasons and because of a complete lack of offers to purchase the property. After 10 more months, the home was purchased by the second set of tenants. The court held that pre-1997 Act Code Section 1034 applied to the sale of the residence, using the market exigencies test that was developed in Clapham.

In Andrews v. Commissioner, T.C. Memo. 1981-247, aff’d in an unpublished opinion, 685 F.2d 429 (4th Cir. 1982), the Tax Court held that pre-1997 Act Code Section 1034 applied where the taxpayer attempted to rent out his old residence for a short period while he made sure his move would be permanent.

The IRS apparently agreed with the market exigencies test, since it acquiesced in Clapham. Additionally, the IRS cited Clapham for the market exigencies exception in PLR 8132017, wherein the IRS ruled that pre-1997

-6-

Act Code Section 1034 applied where the taxpayers moved out of their principal residence and after a few months of unsuccessful attempts to sell the property, rented the home several times for four years, while a broker tried to sell it. The IRS ruled that pre-1997 Act Code Section 1034 applied even though the taxpayers deducted expenses attributable to the temporary rental of the property. However, the IRS did disallow all deductions that exceeded the amount of rent received on the basis that finding pre-1997 Act Code Section 1034 applicable precluded a finding that the residence was held for a business or profit motive.

Cc) REPLACEMENT PERIOD

Cc) Cl) Time period for replacement and occupancy

Pre-1997 Act Code Section 1034 required a taxpayer to purchase and use another residence as the taxpayer’s principal residence within a period beginning two years before and ending two years after the date of sale of the old residence (the replacement period) . <29> For these purposes, the term "purchase" meant a purchase or acquisition of a residence, the exchange of property, or the partial or total construction or reconstruction of a residence. The mere improvement of a residence not amounting to reconstruction did not constitute the purchase of a residence for purposes of pre-1997 Act Code Section 1034. Reg. Section 1.1034-1(b) (9)

The two-year requirement was strictly applied. For example, the courts have held that if construction of the new residence began within the replacement period, but for any reason the taxpayer was unable to occupy it within the replacement period, no extension of time was permitted. <30> In Henzel v. Commissioner, T.C. Memo. 1965-250, the Tax Court held that pre-1997 Act Code Section 1034 did not apply when severe weather prevented completion of the new residence within the replacement period.

Pre-1997 Act Code Section 1034 generally was not satisfied unless the taxpayer physically occupied the new residence within the replacement period. The test of physical occupancy was not satisfied by merely moving furniture or other personal belongings into a residence without actually living there. For example, the Tax Court held that a taxpayer did not satisfy this requirement by moving a few items of furniture into one room of an uncompleted house. <31> This requirement also was not satisfied when a taxpayer purchased a new residence but did not actually occupy it as his principal residence within the required period, <32> even though the taxpayer lived in a house trailer that was adjacent to the home he was constructing, and some of his children occupied the uncompleted house before the end of the statutory period. Lokan v. Commissioner, T.C. Memo. 1979-380.

A good-faith effort was not sufficient to satisfy the time period requirement of pre-1997 Act Code Section 1034. Non-recognition of gain was not allowed even though the failure to meet the replacement deadline was

-7-

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

not the taxpayer’s fault. For example, the courts have held that pre-1997 Act Code Section 1034 did not apply when the taxpayer had been too ill to move, Bazzell v. Commissioner, T.C. Memo. 1967-101, when delays were caused by the FHA, Chavez v. Commissioner, T.C. Memo. 1983-199, or when two successive attempts to buy a replacement residence fell through and resulted in litigation. Henry v. Commissioner, T.C. Memo. 1982-469.

Similarly, occupancy only on weekends and holidays was held insufficient. In Stolk v. Commissioner, 40 T.C. 345 (1963), aff’d per curiam, 326 F.2d 760 (2d Cir. 1964), the taxpayer moved his chief household furnishings into a farm house that he used on weekends and holidays. Although the taxpayer did intend eventually to retire there, the farm house was over 400 miles from his work and New York apartment. The Tax Court held that occupancy only during weekends and holidays did not constitute use of that property as the taxpayer’s principal residence.

Under pre-1997 Act Code Section 1034, an exception to the two-year requirement applied if a taxpayer had a tax home outside the United States following the sale of the old residence. <33> However, the period of suspension could not extend beyond four years from the date of sale of the old residence. Both the husband and wife received the benefit of the extended period if both the old and the replacement homes were their principal residences. The two-year period before the sale of the old residence was not affected by this rule.

In Rev. Rul. 80-326, 1980-2 C.B. 234, the IRS ruled that a taxpayer who was transferred to Puerto Rico did not qualify for the longer extension. According to the IRS, since the Commonwealth of Puerto Rico is treated as a possession or territory of the United States, an individual residing in Puerto Rico was not considered to have a tax home outside the United States.

If, during the replacement period, the taxpayer had more than one principal residence, only the last one acquired was treated as the new residence that qualified for the non-recognition of gain under pre-1997 Act Code Section 1034. <34>

EXAMPLE 7: Lois and Randy sold their old residence on January 15, 1996, and purchased a second residence on February 15, 1996. On March

15, 1996, they sold the second residence and purchased a third residence on April 15, 1996. The gain on the sale of the old residence on January 15, 1996, qualified for non-recognition treatment under pre-1997 Act Code Section 1034 to the extent to which the taxpayers’ adjusted sales price of the old residence exceeded the price of purchasing the third residence. Gain on the sale of the second residence did not qualify for pre-1997 Act Code Section 1034 treatment and therefore had to be recognized. <35>

Pre-1997 Act Code Section 1034 did not apply to the sale of a principal residence if within two years before the date of such sale, the taxpayer sold at a gain another principal residence, and any part of such gain was not recognized under pre-1997 Act Code Section 1034. <36> For taxpayers

-8-

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

who had to relocate more than once during any two-year period, this rule imposed a hardship on such taxpayers. To alleviate this hardship, pre-1997 Act Code Section 1034 Cd) (2) allowed a taxpayer to sell his principal residence more than once within the two-year period and defer gain on each such sale. However, this rule applied only if the subsequent sale was in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work, and the taxpayer satisfied both the geographic and length of employment requirements for deductibility of moving expenses. <37> Taxpayers generally were allowed the benefits of pre-1997 Act Code Section 1034 Cd) (2) where there was a reasonable expectation at the time of the relocation that the taxpayer would be employed, or remain, at the new location for a substantial period of time.

EXAMPLE 8: Adam sold his old residence on January 15, 1996, and purchased a new residence on February 15, 1996. In July, 1996, Adam’s employer permanently transferred him to a new principal place of work 1,000 miles from his former principal place of work and former residence. On August 15, 1996, Adam sold his new residence purchased February 15, 1996. On September 1, 1996, he purchased and used a second new residence as his principal place of work. Since the August 15, 1996, sale occurred within 24 months of the January 15, 1996, sale, the 24-month limitation of pre-1997 Act Code Section 1034 Cd) Cl) ordinarily applied.

However, since the August 15, 1996, sale was in connection with the commencement of work by Adam as an employee in a new principal place of work and since he satisfied the conditions of Code Section 217(c), the 24-month limitation did not apply to the

August 15th sale, and Adam was eligible for non-recognition of treatment on that sale. In addition, the residence sold August 15th was treated as the last new residence used within the 24-month period following the January 15, 1996, sale of Adam’s old residence, and it was an old residence for purposes of running the next 24-month limitation period.

If, however, Adam’s transfer to a new principal place of work was a temporary transfer that he reasonably could have expected to last only 26 weeks, pre-1997 Act Code Section 1034(d) (2) would not apply. As a result, the gain realized on the August 15, 1996, sale was recognized, and the residence purchased on September 1, 1996, was the replacement residence. H.R. Rep. 1445, 95th Cong., 2d Sess. 133-139 (1978)

A sale that met the requirements of pre-1997 Act Code Section 1034(d) (2) terminated the 24-month period and started another 24-month period. Thus, the principal residence that received rollover treatment constituted a new residence with respect to the prior rollover sale and an old residence for purposes of its sale. H.R. Rep. 1445, 95th Cong., 2d Sess. 133-139 (1978). For example, in PLR 8928025, the taxpayer sold his principal residence (Residence 1), in July, Year 1, and purchased a new principal residence CResidence 2) in a different state in connection with the commencement of

-9-

work in that state. In October, Year 2, in connection with a new job in another state, the taxpayer purchased Residence 3. The taxpayer then sold Residence 2 in February, Year 3. The IRS ruled that Residence 2 constituted the new residence with respect to the sale of Residence 1 and that non-recognition treatment also was available for Residence 2, if the sale of Residence 2 was in connection with the commencement of work as an employee at a new principal place of work, and the taxpayer satisfied the conditions of Code Section 217 relating to moving expenses.

Cc) (2) Sale to a corporation to extend replacement period

In situations where the time permitted to sell an old residence after the purchase of a new residence was about to expire under the rules of pre1997 Act Code Section 1034, a taxpayer with a potentially large capital gain that eventually would be realized on the sale of the old home might have felt forced to sell it at a bargain price to avoid the loss of the rollover provisions of pre-1997 Act Code Section 1034. However, there was another way to deal with this problem.

In PLR 9625035, the taxpayers sold their old residence to their wholly owned corporation to meet the statutory time requirements of pre-1997 Act Code Section 1034. The IRS ruled that this sale would preserve their pre-1997 Act Code Section 1034 tax deferral. In so ruling, the IRS stated that there were no specific limitations under pre-1997 Act Code Section 1034 on the manner or nature of the sale, nor was there any prohibition against a sale between related parties. According to the IRS, as long as the requirements of the section were met and gain was realized, the seller had to defer the gain. Thus, the IRS ruled that pre-1997 Act Code Section 1034 applied to a bona fide sale of the taxpayers’ old residence to their corporation if the sale occurred before two years after the purchase of the new residence.

In PLR 9625035, the IRS did not express an opinion as to whether the proposed sale was a bona fide sale. Presumably there would be a bona fide sale if the corporation was a separate tax entity from the taxpayers and not merely their alter ego, the sale was not a sham, and the sale price was reasonable under the circumstances. If the sale were a bona fide sale, but the price was set at an unreasonably high level, the excess over a reasonable price would be a taxable dividend rather than a deferred gain on the sale of the residence if the corporation had current or accumulated earnings and profits at the time of the sale.

The IRS expressed no opinion in PLR 9625035 about the tax consequences of such a sale other than under pre-1997 Act Code Section 1034. In PLR 8350084, which also dealt with the sale of a couple’s principal residence to the husband’s wholly owned corporation, the IRS did address a related issue. In addition to pre-1997 Act Code Section 1034, the taxpayers in PLR 8350084 requested a ruling as to whether Code Section 1239, which requires gain to be recharacterized as ordinary income on the sale of property to a controlled entity if a controlled entity intends to hold the property as depreciable property, would interfere with the provisions

10 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

of pre-1997 Act Code Section 1034. The IRS ruled that it would not, but stated that if the replacement residence was later sold and gain recognized, that gain would be ordinary income to the extent of the gain that would have been ordinary income on the sale of the old residence to the corporation had it not been for the pre-1997 Act Code Section 1034 deferral.

(d) COST OF THE NEW RESIDENCE

The taxpayer’s cost of purchasing a new residence includes not only cash, but also any indebtedness to which the property purchased is subject at the time of purchase, whether or not assumed by the taxpayer (including a purchase money mortgage), and the face amount of any liabilities of the taxpayer that are part of the consideration for the purchase. Reg. Section 1.1034-1 Cc) (4) Ci). Commissions and other purchasing expenses paid or incurred by the taxpayer on the purchase of the new residence are included in determining such costs. In the case of an acquisition of a residence by exchange, the fair market value of the new residence on the date of the exchange is considered as the taxpayer’s cost of purchasing the new residence. <38> The cost of purchasing the new residence includes only such amounts as are properly chargeable to capital accounts rather than to current expenses. <39> The value of any part of the new residence acquired by the taxpayer other than by purchase is not to be included in determining the cost of the new residence. Reg. Section

1.1034-1 Cc) (4) Ci). If the taxpayer acquired a new residence by either gift or inheritance and sold the old residence within the non-recognition period, the cost of purchase for purposes of determining the amount of recognized gain did not include the value or basis of acquired property. The property was considered purchased only to the extent that the taxpayer spent money in reconstructing it. For example, if the taxpayer acquired a residence by gift or inheritance, and spent $60,000 in reconstructing such residence, only $60,000 would be treated as the taxpayer’s cost of purchasing the new residence.

The taxpayer’s cost of purchasing the new residence included only costs attributable to acquisition, construction, reconstruction, or improvements that were made within the replacement period, i.e., the period of time during which the purchase and use of the new residence had to be made in order to have gain on the sale of the old residence not recognized. Thus, if the construction of the new residence began four years before the date of sale of the old residence and completed on the date of the sale of the old residence, only costs incurred during the last 24 months of construction constituted the taxpayer’s cost of purchasing the new residence for purposes of pre-1997 Act Code Section 1034. Reg. Section 1.1034-1(c) (4) (ii)

The cost of a new residence did not include the value of a new residence just before its reconstruction where the taxpayer had purchased the to-be-reconstructed residence long before the statutory period. Shaw v. Commissioner, 69 T.C. 1034 (1978) . The IRS ruled that the cost of a new residence did not include rent-free housing provided by a builder to

- 11 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

induce the taxpayer to buy. Rev. Rul. 78-162, 1978-1 C.B. 255. In Rev. Rul. 72-266, 1972-1 C.B. 227, the IRS ruled that the cost of a residence did not include the present value of rent payments for a 50-year lease of the land on which the new residence was situated. <40> The Tax Court held that the cost of a new residence did not include the cost of the lot on which the new residence (a mobile home) was located when the lot was not purchased before or in conjunction with the acquisition of the factory-made mobile home. Evans v. Commissioner, T.C. Memo. 1982-623.

Ce) SPECIAL RULES FOR MILITARY PERSONNEL

Pre-1997 Act Code Section 1034 Ch) provided two special rules that extended the period for acquisition of a new residence after the sale of the old residence for members of the armed forces. First, pre-1997 Act Code Section 1034(h) Cl) suspended the running of the replacement period during any time that the taxpayer served on extended active duty with the armed forces of the United States. <41> With one exception, this suspension could not be extended more than four years after the date of the sale of the old residence. The one exception occurred during the time a member of the armed forces was on active duty in a combat zone and for 180 days thereafter. <42>

Second, pre-1997 Act Code Section 1034(h) C2) extended the replacement period if, at any time during the first four years that the member of the armed forces was on extended active duty, he was either stationed outside the United States or, after returning from a tour of duty outside the United States, was stationed at a remote base site where a determination was made by the Secretary of Defense that adequate off-base housing was not available such that the taxpayer had to reside in on-base government quarters. In that case, the replacement period did not expire until one year after the date on which the member of the armed services was no longer stationed outside the United States or was no longer required to reside in on-base quarters, but in no event longer than eight years from the date of sale of the old residence. The period before the sale of the old residence was not suspended. Reg. Section 1.1034-1(g) (4).

This special extension was available to both spouses, even though only one of them was in the service, if the same spouses used both the old and new residences as their principal residences. Reg. Section 1.1034-1(g) (2) In the event of a divorce, the special extension period stopped at the time of divorce for the spouse who was not in the service. Rev. Rul.

78-136, 1978-1 C.B. 259.

Cf) MECHANICS OF PRE-1997 ACT CODE SECTION 1034

Generally, gain was recognized under pre-1997 Act Code Section 1034 only to the extent that the adjusted sales price of the old residence exceeded the cost of the new residence. <43> The adjusted sales price was the amount realized on the sale of the old residence, reduced by the fixing-up expenses. Reg. Section l.1034-lCb) (3).

- 12 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

The amount realized was computed by subtracting from the gross selling price the expenses of the sale. The selling price included the amount of money, the fair market value of property received, debt relief, and debt secured by the property that was assumed or taken subject to by the buyer. Selling expenses included commissions, expenses of advertising the property for sale, preparing the deed, and other legal services in connection with the sale. Reg. Section 1.1034-1(b) (4) In addition, the Tax Court held that selling expenses included advertising and telephone costs, realtor’s commissions, the cost of title insurance, documentary stamp taxes, fees for document preparation, and escrow fees. Martin v. Commissioner, T.C. Memo. 1960-140.

Fixing-up expenses were the expenses for work performed on the old residence in order to assist in its sale. Expenses qualified as fixing-up expenses if they were:

Cl) incurred for work performed during the 90-day period ending on the day on which the contract to sell the old residence is entered into;

(2) paid on or before the 30th day after the date of the sale of the old residence; and

(3) neither allowable as deductions in computing taxable income, nor taken into account in computing the amount realized from the sale of the old residence. Reg. Section 1.1034-1(b) (6).

Expenses were not considered in figuring the adjusted sales price if the contract to sell did not result in a completed sale or where a second contract with a different buyer was entered into over 90 days later, and the sale of the residence was completed under the second contract. Rev. Rul. 72-118, 1972-1 C.B. 227. Fixing-up expenses did not include expenditures that were properly chargeable to a capital account and would therefore constitute adjustments to the basis of the old residence. Reg. Section 1.1034-1(b) (6).

In determining the amount of gain deferred by pre-1997 Act Code Section 1034, the commissions and other selling expenses were first subtracted from the selling price of the old residence to determine the amount realized. If the amount realized exceeded the cost or other basis, the amount of the excess was the gain realized. If the amount realized was not greater than the cost or other basis, no gain was realized, and pre-1997 Act Code Section 1034 did not apply, nor was the taxpayer entitled to recognize a loss. <44>

To determine the adjusted sales price, the amount realized was reduced by the fixing-up expenses (if any) . If the cost of purchasing the new residence was the same as, or greater than, the adjusted sales price of the old residence, none of the realized gain was recognized. However, if the cost of purchasing the new residence was less than the adjusted sales price of the old residence, the realized gain was recognized under pre1997 Act Code Section 1034 to the extent of the difference. All capital

- 13 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

expenditures attributable to the construction, reconstruction, and improvement of the taxpayer’s new residence qualified as part of the cost of the new residence if such expenditures were paid or incurred during the replacement period. <45>

EXAMPLE 9: Randy decided to sell his residence that has a basis of $87,500. To make it more attractive to buyers, he painted the outside at a cost of $1,500 in April, 1996. He paid for the painting when the work was finished. In May, 1996, he sold the house for $100,000. Brokers’ commissions and other selling expenses were $5,000. In October, 1996, Randy bought a new residence for $90,000. Under pre1997 Act Code Section 1034, the amount realized, the gain realized, the adjusted sales price, and the recognized gain were computed as follows:

Selling Price

Less: Commissions and other selling expenses

Amount realized

Less: Basis

Gain realized

Amount realized

Less: Fixing up expenses

Adjusted sales price

Less: Cost of purchasing new residence

Gain recognized

$100,000 (5, 000)

95,000

(87, 500)

$ 7,500

$ 95,000

(1,500)

$ 93,500

C90, 000)

$ 3,500

The adjusted basis of the new residence was computed as follows:

Replacement cost

Gain realized (but not recognized)

Adjusted basis of new residence

$ 90,000 (4, 000)

$ 86,000

EXAMPLE 10: Assume the same facts as Example 9, except that the selling price of the old residence was $92,500. Under pre-1997 Act Code Section 1034, the amount realized and the gain realized were computed as follows:

Selling Price

Less: Commissions and other selling expenses

Amount realized

Less: Basis

Gain realized

$ 92,500 (5, 000)

87,500

(87, 500)

- 14 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Since no gain was realized, pre-1997 Act Code Section 1034 was inapplicable. As a result, it was unnecessary to compute the adjusted sales price of the old residence and compare it with the cost of purchasing the new residence. Also, adjustment to the basis of the new residence was not required. Randy’s basis in his new residence was the purchase price of $90,000.

EXAMPLE 11: Assume the same facts as Example 9, except that the cost of purchasing the new residence was $85,000. Under pre-1997 Act Code Section 1034, the computations were as follows:

Selling price

Less: Commissions and other selling expenses

Amount realized

Less: Basis

Gain realized

Amount realized

Less: Fixing up expenses

Adjusted sales price

Cost of purchasing new residence

Gain recognized

$100,000 Cs, 000)

95, 000

(87, 500)

$ 7,500

$ 95,000

(1,500)

$ 93,500

85,000

$ 7,500

Since the adjusted sales price of the old residence exceeded the cost of purchasing the new residence by $8,500, which was more than the gain realized, all of the gain realized was recognized. No adjustment to the basis of the new residence was required. Randy’s basis in the new residence was its cost of $90,000.

EXAMPLE 12: Assume the same facts as Example 9, except that the fixing-up expenses were $5,500. Under pre-1997 Act Code Section 1034, the computations were as follows:

Selling price

Less: Commissions and other selling expenses

Amount realized

Less: Basis

Gain realized

Amount realized

Less: Fixing up expenses

Adjusted sales price

Cost of purchasing new residence

$100,000 (5, 000)

$ 95,000

(87, 500)

$ 7,SOO

$ 9S,000

Cs, 500)

$ 89,500

90, 000

- 1S -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Gain recognized $ 0

Since the cost of purchasing the new residence exceeded the adjusted sales price, none of the gain realized was recognized. The adjusted basis of the new residence was computed as follows:

Replacement cost $90,000
Gain realized but not recognized (7,500)

Adjusted basis of new residence $82,500

The adjustment to basis for the gain not recognized included only so much of the gain as was not recognized up to the date of the determination of the adjusted basis.

EXAMPLE 13: On January 1, 1996, Fred bought a new residence for $50,000. On March 1, 1996, he sold for an adjusted sales price of

$75,000 his old residence, which has an adjusted basis to him of

$25,000. Between April 1 and April 15 of 1996, a wing was constructed on the new house for $25,000. Between May 1 and May 15 of 1996, a garage was constructed for $10,000. The adjusted basis of the new residence was $50,000 during January and February, $25,000 during March, $25,000 following the completion of the construction in April, and $35,000 following the completion of the construction in May. Since the old residence was not sold until March 1, 1996, no adjustment to the basis of the new residence was made during January and February. The gain realized on the sale of the old residence, and the computations for March, April, and May were as follows:

Amount realized on the sale of old residence $75,000

Plus: Adjusted basis of old residence 25,000

Gain realized on the sale of old residence $50,000

March 1, 1996

Adjusted sales price for old residence $75,000

Less: Cost of purchasing new residence (50,000)

Gain recognized $25,000

Gain realized but not recognized $25,000

Cost of purchasing new residence $50,000

Less: Gain realized but not recognized (25,000)

Adjusted basis of new residence $25,000

April 15, 1996

- 16 -

Gain realized on sale of old residence $50,000

Adjusted sales price for old residence $75,000

Less: Cost of purchasing new residence (75,000)
Gain recognized $0
Gain realized but not recognized $50,000

Cost of purchasing new residence $75,000
Less: Gain realized but not recognized (50,000)
Adjusted basis of new residence $25,000

May 15, 1996

Gain realized on sale of old residence $50,000

Adjusted sales price of old residence $75,000

Less: Cost of purchasing new residence (85,000)
Gain recognized $0
Gain realized but not recognized $50,000

Cost of purchasing new residence $85, 000
Less: Gain realized but not recognized (50,000)
Adjusted basis of new residence $35,000

Cg) IMPROVEMENTS TO PREVIOUSLY OWNED PROPERTY

Under pre-1997 Act Code Section 1034, a residence that the taxpayer constructed or reconstructed could have qualified as a replacement residence. Pre-1997 Act Code Section 1034 Cc) (2). Of course, the reconstructed residence had to be occupied as a principal residence within the replacement period (see pre-1997 Act Code Section 1034 Ca)), and only costs incurred during the replacement period qualified as costs of acquiring a new principal residence. <46>

Unlike partial or total construction or reconstruction, the mere improvement of a residence did not qualify as a purchase of a residence. Reg. Section 1.1034-1(b) (9) Recreational, aesthetic, or maintenance type improvements such as the addition of a poo1 or tennis court, landscaping, or a roof replacement were considered mere improvements. However, extensive mechanical and structural additions and alterations, such as rebuilding porches, expanding basements, and building a new roof qualified as the construction or reconstruction of a residence. <47>

(h) BUSINESS USE OF PERSONAL RESIDENCE

- 17 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Where part of the taxpayer’s principal residence was used for purposes other than as a residence, such as a home office used in the taxpayer’s trade or business, the benefits of pre-1997 Act Code Section 1034 applied only to the portion used as a residence. Further, if part of the new residence was used for business purposes, only the cost attributable to the acquisition of the residential portion was pertinent in determining the amount of gain not recognized on the sale of the old residence. Reg. Section 1.1034-1(c) C3) Cii)

Where a portion of the taxpayer’s residence was used as an office, and the taxpayer was allowed a business deduction for that home office under Code Section 280A, then an allocation was required. However, if the taxpayer’s residence was not used in the taxpayer’s trade or business in the year sold, an allocation was not required, even though a portion of the residence had been previously used in the taxpayer’s trade or business and deductions for the business use had been taken in previous years. Rev.

Rul. 82-26, 1982-1 C.B. 114.

Minimal business use of the taxpayer’s residence, however, did not preclude the taxpayer from using the full benefits of pre-1997 Act Code Section 1034. For example, use of only a portion of a taxpayer’s house for storage of tools and supplies used in the taxpayer’s trade or business was too insignificant to require an allocation of a portion of the cost to business usage. <48> The Supreme Court permitted deferral of gain under pre-1997 Act Code Section 1034 where such gain was attributable to the one unit of a triplex that the taxpayer-owner occupied and where he rented out the other two units. United States v. Darusmont, 449 U.S. 292 (1981)

EXAMPLE 14: Dan sold his principal residence, which was used in his trade or business. Seventy-five percent of the square footage was used for Dan’s personal living accommodations and 25 percent was used in his trade or business. Dan had an adjusted basis (after depreciation) of $87,500 at the time of disposition, of which $65,625 was allocable to personal use and $21,875 to business use. To make the house more attractive to buyers, Dan painted the outside at a cost of $1,500. He paid for the painting when the work was finished. He sold the house for $100,000. Brokers’ commissions and other selling expenses were $5,000. Within two months after the sale, Dan purchased a new residence for $90,000, of which 75 percent will be used for his personal living accommodations and the other 25 percent devoted to his trade or business. Under pre-1997 Act Code Section 1034, the amount realized, the gain realized, the adjusted sales price, and the gain recognized were computed as follows:

Total Personal Business

Selling Price $100,000 $ 75,000 $ 25,000

Less: Commissions and other

selling expenses 5,000 3,750 1,250

Amount realized 95,000 71,250 23,750

Less: Basis (87,500) (65,625) (21,875)

- 18 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Gain realized $ 7,500 $ 5,625 $ 1,875

Amount realized 95,000 71,250
Less: Fixing up expenses (1,500) (1,125)

Adjusted sales price 93,500 70,125

Less: Cost of purchasing new

residence (90,000) (67,500)

Gain recognized $3,500 $ 2,625 $ 875

Gain realized but not recognized $ 4,000
Adjusted basis of new residence
($90,000 minus $4,000) $ 86,000

Dan must recognize gain of $875 for that portion of the residence sold that was attributable to the trade or business use and $2,625 of gain for that portion that was attributable to the sale of his personal residence. In addition, Dan should be entitled to a deduction of $375 ($1,500 minus 1,125) for that portion of the fixing-up expenses that was attributable to the business use of the property.

(i) TAXABLE EXCHANGES

If a taxpayer exchanged his personal residence for another, it was possible that the exchange could have been treated as a taxable sale or exchange to which pre-1997 Act Code Section 1034 may have applied. In general, unless the taxpayer’s personal residence (or a portion of the residence) is held for productive use in a trade or business or for investment, the like-kind exchange provisions of Code Section 1031 are not available to an exchange of personal residences. <49>

If a portion of both the old and new residences are used in the taxpayer’s trade or business, that portion that is used in the taxpayer’s trade or business qualifies for like-kind exchange treatment. Sayre v. United States, 163 F. Supp. 495 (S.D. W. Va. 1958). Any other property received, including the personal portion of the residence, is considered boot. Realized gain must be recognized to the extent of such boot received. Code Section 1031 (b) . Boot must be allocated between the business use and the personal use of the exchanged residences, based on their relative fair market values. Sayre v. United States, 163 F. Supp. 495 (S.D. W. Va. 1958)

EXAMPLE 15: Andre exchanged his residence, used 30 percent for business and 70 percent for personal purposes, for another residence that is to be used 40 percent for business and 60 percent for personal purposes. He had an adjusted basis of $60,000 in the

- 19 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

residence exchanged, of which $50,000 was attributable to the personal use of the residence and $10,000 to business use. He received a residence worth $100,000 and $20,000 cash. Under pre-1997 Act Code Section 1034, the amount realized, the gain realized, the adjusted sales price, and the gain to be recognized were computed as follows:

Total Personal Business

Selling Price

(Residence worth $100,000

+ cash of $20,000) $120,000 $ 84,000 $ 36,000

Less: Commissions and

other selling expenses 0 0 0

Amount realized $120,000 $ 84,000 $ 36,000
Less: Basis (60,000) (50,000) (10,000)

Realized gain $ 60,000 $ 34,000 $ 26,000

Under Code Section 1031, the $20,000 of boot is

allocated in proportion to the relative fair market value of personal and business portions of the property exchanged. Thus, $14,000 of the cash received is allocable to the personal use of the residence and $6,000 is allocable to business use. Andre must recognize gain of

$6,000 for the boot allocated to the business use. In addition, Andre has a $10,000 adjusted basis in the new residence attributable to its business use (old basis of $10,000 + gain recognized of $6,000 minus boot received of $6,000). <50>

No additional gain was recognized for the personal portion of the residence exchanged, since that part of the exchange qualified for non-recognition under pre-1997 Act Code Section 1034. Andre’s adjusted selling price of $84,000 equaled his replacement cost of $84,000 (70 percent x $120,000). Thus, Andre had a $50,000 adjusted basis in the new residence attributable to its personal use (replacement cost of $84,000 less realized gain not recognized of $34,000) . Andre’s total adjusted basis in the new residence equaled

$60,000 C$50,000 attributable to personal use + $10,000 attributable to business use)

Ci) CONDEMNATION OF PERSONAL RESIDENCE

For purposes of pre-1997 Act Code Section 1034, a taxpayer could have elected to treat the seizure, requisition, or condemnation of his principal residence, or the sale or exchange of the residence under threat or imminence thereof, as the sale of the residence. Former Code Section 1034(i). Thus, a taxpayer could have elected to have pre-1997 Act Code

- 20 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Section 1034 apply, rather than Code Section 1033 (relating to involuntary conversions), in determining the amount of gain realized on the disposition of the old residence that did not have to be recognized. Once made, this election was irrevocable. Reg. Section 1.1034-1(h) C2) Ci). The election to treat the condemnation of the personal residence as a sale was made in a statement attached to the taxpayer’s income tax return when filed for the taxable year during which the disposition of the old residence occurred. <51>

OBSERVATION: In general, if condemnation proceeds are less than the taxpayer’s basis in such residence, the taxpayer is not entitled to recognize a loss because it does not fall within one of the three categories of loss an individual is entitled to deduct under Code Section 165 Cc) (i.e., it is not incurred in a transaction entered into for profit, in a trade or business, or as a result of a casualty loss)

(k) DESTRUCTION BY CASUALTY

Under pre- and post-1997 Act law, if a taxpayer’s residence is destroyed by casualty, different rules apply depending on whether the insurance proceeds received exceed the taxpayer’s basis in the residence. If the insurance proceeds exceed basis, gain must be recognized, unless deferred by Code Section 1033 Ci.e., gain on an involuntary conversion). If the insurance proceeds are less than the taxpayer’s basis, the taxpayer may be entitled to a casualty loss deduction. Generally, a realized loss is measured by the lesser of the difference in the fair market value of the residence immediately before and after the casualty or the taxpayer’s basis in the residence. Reg. Section 1.165-7(b) Cl). If the realized loss exceeds any insurance proceeds, the taxpayer may be entitled to deduct the loss to the extent it exceeds $100 per occurrence, and the taxpayer’s overall casualty loss for the year exceeds 10 percent of AGI. <52>

If the insurance proceeds exceed basis, Code Section 1033 rather than pre-1997 Act Code Section 1034 applied. Thus, gain is recognized only to the extent that the insurance proceeds exceed the cost of qualifying replacement property purchased by the taxpayer within the appropriate replacement period, if the taxpayer had elected the provisions of Code Section 1033. <53> To qualify under Code Section 1033, the taxpayer must purchase another principal residence <54> within a period of time that begins on the date of destruction and ends two years after the close of the taxable year in which gain is first realized. <55>

Under Code Section 1033, the taxpayer’s cost basis in the replacement residence is reduced by the amount of realized gain not recognized (i.e., the taxpayer’s basis in the new residence is replacement cost less the realized gain not recognized) . Code Section 1033 Cb)

EXAMPLE 16: Terry’s house was destroyed on October 28, 1993, and she received $110,000 as an insurance settlement on January 18, 1994. She had a $30,000 adjusted basis in the house. Thus, she realized $80,000

- 21 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

of gain ($110,000 of insurance proceeds less adjusted basis of $30,000) . If Terry did not elect Code Section 1033 treatment, she would have to recognize the $80,000 gain, and pre-1997 Act Code Section 1034 was not available since the collection of the insurance proceeds was not considered a taxable sale or exchange. However, if Terry elected Code Section 1033 treatment, she must purchase another principal residence costing at least $110,000 between October 28, 1993, and December 31, 1996. If Terry’s replacement residence costs only $90,000, she must recognize a $20,000 gain, and her adjusted basis in the replacement residence would be $30,000 ($90,000 cost less $60,000 realized gain not recognized)

If the dwelling portion of the taxpayer’s principal residence is destroyed, and the remaining land portion of the principal residence is subsequently sold within the period described in Code Section 1033 Ca) C2) CB), the sale of the land is treated as part of the involuntary conversion of the principal residence to which Code Section 1033 applies. If the taxpayer subsequently sells the land portion of the principal residence within a reasonable period of time after the destruction, the property will continue to be treated as a qualified residence under Code Section 163 Ch) during the period between the destruction of the dwelling and the sale of land. Likewise, if the taxpayer reconstructs the destroyed dwelling and reoccupies it as his principal residence within a reasonable period of time after the destruction, the property will continue to be treated as a qualified residence under Code Section 163 (h) during that period. Rev. Rul. 96-32, 1996-1 C.B. 177.

OBSERVATION: For a discussion of this issue under post-1997 Act law, see Section 80.2(i).

(1) FORECLOSURES

The transfer of property either by a foreclosure sale or a deed in lieu of foreclosure is treated as a taxable sale or exchange (Helvering v. Hammel, 311 U.S. 504 (1941)), and the taxpayer realizes a gain or loss measured by the difference between the foreclosure proceeds and the adjusted basis in the residence. <56>

If property is sold in a foreclosure sale, the general rule is that the amount realized equals the greater of the sales proceeds or the face amount of the debt if the sale is to a third party and equals the bid price if the sale is to the creditor. <57> In the case of foreclosure of the taxpayer’s principal residence, if the foreclosure proceeds exceeded the taxpayer’s basis, pre-1997 Act Code Section 1034 may have applied. In addition, the taxpayer could have elected under pre-1997 Act Code Section 121 to exclude all or a portion of the gain realized. <58> If the foreclosure proceeds were less than the taxpayer’s basis, the taxpayer was not entitled to recognize a loss, <59> In addition, discharge of indebtedness income may be recognized under Code Section 108 with respect to property sold in a foreclosure sale. <60>

- 22 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Cm) INSTALLMENT SALES

The fact that some gain on the sale of a principal residence was deferred under pre-1997 Act Code Section 1034 did not prevent a taxpayer from using the installment method to report any gain that was not so deferred. <61> Of course, the taxpayer could have elected out of the installment sale provisions. Code Section 453(d).

If pre-1997 Act Code Section 1034 applied, and if the sale of the taxpayer’s principal residence qualified for installment reporting, <62> the amount of gain reported in any year equaled the payment received multiplied by the gross profit ratio. <63> For these purposes, the gross profit ratio equaled gross profit divided by the total contract price. <64> Gross profit equaled the selling price of the principal residence less the adjusted basis (plus selling expenses not deducted as moving expenses). Reg. Section 15A.453-lCb) (2) Cv). The selling price included the gross selling price without reduction for mortgages or expenses of sale and excluding any unstated interest or original issue discount included by the parties in the selling price. <65> The contract price equaled the selling price reduced by the seller’s qualifying indebtedness assumed or taken subject to by the purchaser plus the qualifying indebtedness that exceeded the sum of the taxpayer’s adjusted basis plus selling expenses not deducted as moving expenses. Reg. Section lSA.453-l(b) (2) Ciii). Qualifying indebtedness included mortgages and other indebtedness encumbering the residence or assumed by the purchaser in acquiring the residence, but did not include any indebtedness that was not functionally related to holding, acquiring, or operating the property sold. Reg. Section 15A.453-l(b) (2) (iv). The above stated rules may be expressed in the following formula:

Selling price xxx

Less: Adjusted basis xxx

Plus: Expenses of sale xxx

Gross profit of sale xxx

Selling price xxx
Less: Debt relief xxx
Plus: Debt relief in
excess of adjusted
basis + expenses of
sale) xxx

Total contract price xxx

A taxpayer’s gross profit ratio equals the taxpayer’s gross profit divided by the total contract price. The amount of gain to be reported in the year of sale equals the taxpayer’s gross profit ratio multiplied by the payments received in such year. Payments include not only cash, but also any indebtedness directly or indirectly secured by cash or cash

-- 23 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

equivalents. Reg. Section 15A.453-l(b) (3) (i) . Payment also includes the receipt of any property, including any indebtedness payable on demand or readily tradable, but does not include the purchaser’s installment obligation unless it is payable on demand. Reg. Section

lSA.453-1 Ce) (1) Ci). Assumption by the purchaser of the seller’s debt on the property generally is not included as a payment received in the year of sale except to the extent that the amount of such mortgage exceeds the seller’s adjusted basis in the residence increased by the selling expenses not deducted as moving expenses. Reg. Section 15A.453-l(b) (3) Ci)

If a sale qualified for pre-1997 Act Code Section 1034 treatment, the seller’s gross profit did not include any gain that was deferred by pre 1997 Act Code Section 1034. <66>

Cn) MARRIED TAXPAYERS

If a husband and wife held title to the old residence jointly, sold the old residence, and jointly acquired a new residence within the replacement period, they were treated as a single unit and the non-recognition provisions of pre-1997 Act Code Section 1034 automatically applied to them jointly.

In other situations, married taxpayers could have consented to be treated as one person for purposes of applying the provisions of pre-1997 Act Code Section 1034. <67> If the married taxpayers consented to being treated as one person, the adjusted sales price included the adjusted sales price of both spouses’ old residences, and the cost of the new residence included the cost to both spouses of the new residence. <68> A consent could be filed only if the old residence and the new residence were each used by both taxpayers as their principal residence. <69> Thus, a taxpayer who divorced and remarried was not eligible under Reg. Section 1.1034-1(f) to file a consent covering the sale of the prior residence with the former spouse and the purchase of a new residence with the new spouse. Note, however, that this regulation was held invalid by the Fourth Circuit in Snowa v. Commissioner, 123 F.3d 190 (4th Cir. 1997), rev’g T.C. Memo. 1995-336. In Snowa, the Fourth Circuit held that the pre-1997 Act Code Section 1034(g) election should be available to all married taxpayers, even those who divorce and remarry during the two-year replacement period of pre-1997 Act Code Section 1034. <70>

If both spouses did not consent, pre-1997 Act Code Section 1034 was applied separately to each spouse where either the old residence or the new residence or a combination thereof was not jointly owned by both taxpayers. Pre-1997 Act Code Section 1034(g). In this case, each taxpayer’s gain on the sale of the old residence was recognized to the extent that the taxpayer’s share of the adjusted sales price of the old residence exceeded the taxpayer’s contribution to the cost of the new residence.

Where married taxpayers consented to be treated as one person for purposes

- 24 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

of applying pre-1997 Act Code Section 1034 (Snowa v. Commissioner, 123 F.3d 190 (4th Cir. 1997), rev’g T.C. Memo. 1995-336 ), it did not matter how the title of the new or old residences was held. That is, the husband or wife could have owned the old residence separately, and title to the new residence was in both names; or title to the old residence was in both names and title to the new residence was in one or the other; or title to the old residence was in one spouse’s name and title to the new residence was in the other spouse’s name.

It also did not matter that the proceeds of the sale were divided differently from the payment of the purchase price because the basis of the new residence attributable to realized gain that was not recognized was allocated between them. Reg. Section l.1034-lCf) (2).

EXAMPLE 17: Brittany sold for an adjusted sales price of $100,000 the principal residence of herself and her husband Michael, which she owned individually and that had an adjusted basis to her of $50,000. Within a year after the sale, they each contributed $50,000 from their separate funds for the purchase of their new principal residence, which they held as tenants in common, each owning an undivided one-half interest therein. If they filed the required consent, the gain of $50,000 on the sale of the old residence was not recognized by Brittany, her adjusted basis in the new residence was $25,000, and Michael’s adjusted basis was $25,000.

EXAMPLE 18: Michael and Brittany sold their principal residence for an adjusted sales price of $100,000. They owned the residence as joint tenants, and each had an adjusted basis of $25,000 ($50,000 together). Within a year after the sale, Michael spent $100,000 of his own funds in the purchase of a common principal residence and took title in his name only. If they filed the required consent, their adjusted basis in the new residence was $50,000 ($25,000 each), and the gain on the sale of the old residence was not recognized.

(0) EFFECT OF DIVORCE

Divorced, separated, and divorcing taxpayers were eligible to defer the recognition of gain realized on the sale of their principal residences under pre-1997 Act Code Section 1034 as any other taxpayers. However, as discussed below, the technical rules of pre-1997 Act Code Section 1034 were applied strictly in the divorce context, thereby creating a number of traps for the unwary.

(o) (1) Joint sale of residence before divorce

Under pre-1997 Act Code Section 1034, married taxpayers who sold their principal residence and divorced before acquiring a new home were each treated as selling one half of the marital residence and had to acquire a new residence that cost half as much as the selling price of the marital residence in order to defer all of the gain on the sale under pre-1997 Act Code Section 1034. Rev. Rul. 74-250, 1974-1 C.B. 202. Each spouse was

- 25 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

treated as selling one half of the residence, even if the court awarded more than half of the proceeds to one spouse and less than half to the other. Urbauer v. Commissioner, T.C. Memo. 1997-227. However, a spouse who acquired a new residence may have been required to pay the tax on the gain on the sale of the other spouse’s half, if the sale of the marital residence was reported on a joint return, and the other spouse failed to reinvest. <71>

(o) (2) Purchase of new residence with new spouse

Under pre-1997 Act Code Section 1034, married taxpayers who sold separately owned residences and jointly purchased a new residence were eligible to defer the recognition of gain realized on the sale of both of the prior residences. However, there was a division of authority on the issue of whether each spouse had to reinvest at least an amount equal to his selling price. Under the Tax Court rule (Snowa v. Commissioner, T.C. Memo. 1995-336, rev’d, 123 F.3d 190 (4th Cir. 1997)) and the regulations (Reg. Section 1.1034-1(f)), the pre-1997 Act Code Section 1034(g) election, which permitted a married taxpayer to include his spouse’s investment in the cost of the new residence, was not available unless the couple used both the old and new residences as their principal residence. However, the Fourth Circuit reversed the Tax Court and held that the regulations are invalid on this point. Snowa v. Commissioner, 123 F.3d 190 (4th Cir. 1997), rev’g T.C. Memo. 1995-336.

OBSERVATION: Under the Tax Court rule, if the spouses took title as joint tenants, each was treated as incurring only half of the cost of the new residence. <72> Thus, spouses who sold prior residences of unequal value may have had a tax liability on one of the prior sales even though the new residence cost more than the total selling prices of the two prior residences. For this reason, where each spouse entered a marriage owning a home, care needed to be exercised to avoid a current tax when one home Cor both) was sold and replaced. <73> On the other hand, by holding invalid that portion of the regulations that limited the pre-1997 Act Code Section 1034 Cg) election, the Fourth Circuit seems to have made it possible for married couples to have elected to include the investment of his spouse in the cost of the new residence. Under pre-1997 Act law, it would seem that the spirit of the opinion, if not the letter, would have permitted partial elections as well.

Co) (3) Effect of moving out of marital home before sale

Typically, upon deciding to get a divorce, one spouse moves out of the marital home while the other remains. Often, the home is sold pursuant to property settlement negotiations, with the proceeds allocated between the spouses. In this situation, the spouse who moved out of the home generally was ineligible for pre-1997 Act Code Section 1034 treatment because, as the result of moving out, the marital home was no longer his principal residence at the time of the sale.

- 26 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

For example, in Perry v. Commissioner, T.C. Memo. 1994-247, aff’d, 91 F.3d 82 (9th Cir. 1996), under the terms of the marital settlement agreement, the taxpayer’s former wife had the exclusive right to occupy the marital home temporarily until it was sold two years after their divorce. The taxpayer did not have a right to reside at the residence, and in fact he did not physically occupy and live in the dwelling. Therefore, the Tax Court held that the home was not his principal residence. In so holding, the Tax Court stated that the Perry facts were distinguishable from the Clapham <74> line of cases where the taxpayers had listed the property for sale upon their departure, and the delayed sale was caused by external factors such as a poor real estate market.

Cp) REPORTING REQUIREMENTS

When the sale of the old residence occurred in one year and the new residence either had not yet been purchased or details were not final at the time that the return for the year of sale was due, the taxpayer used Form 2119, Sale of Your Home, to report the sale. If the taxpayer subsequently acquired or constructed a new residence and otherwise met the requirements for non-recognition of gain under pre-1997 Act Code Section 1034, the taxpayer had to notify the District Director of this fact by filing another Form 2119 with the current year’s tax return.

If the taxpayer did not acquire a new residence of sufficient cost to defer recognition of all gain, the statute of limitations for the assessment of the deficiency attributable to any such gain could not expire before the expiration of three years from the date of receipt, by the District Director with whom the return was filed for the taxable year or years in which the gain from the sale of the old residence was realized, of a written notice from the taxpayer of:

(1) The taxpayer’s cost of purchasing the new residence that the taxpayer claimed resulted in non-recognition of any part of such gain;

(2) the taxpayer’s intention not to purchase a new residence within the period when such a purchase resulted in non-recognition of any part of such gain; or

(3) the taxpayer’s failure to make such a purchase within such period. Reg. Section 1.1034-1(i)

Any gain that had to be recognized from the sale in a prior year had to be included in gross income for the taxable year or years in which such gain was realized, i.e., the year in which the old residence was sold. In such a case, the taxpayer had to file an amended return for the year in which the gain from the sale of the residence was realized. Reg. Section

1.1034-1(i).

- 27 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

15/ For a discussion of the post-1997 Act rules relating to the sale or exchange of a personal residence, see Section 80.2

16/ A special four-year limit applied to certain members of the military and persons whose tax homes were outside the United States. Pre1997 Act Code Section 1034 Ch) and pre-1997 Act Code Section 1034 Ck) . See Section 80.3(c) Cl) and Section 80.3(e) for a discussion of these rules.

17/ Pre-1997 Act Code Section 1034(a); Reg. Section

1.1034-1(c) (3) (i)

18/ Reg. Section 1.1034-1 Cc) C3) Ci). The mere fact that property was, or had been, rented was not determinative that such property was not used by the taxpayer as the taxpayer’s residence. Reg. Section 1.1034-1(c) (3) Ci) . Note that the IRS will not issue advance rulings or determination letters with respect to whether, for purposes of pre-1997 Act Code Section 1034, property qualifies as the taxpayer’s principal residence. Rev. Proc. 99-3, 1999-1 I.R.B. 103, Section 3.01(6).

19/ Reg. Section 1.1034-1Cc) (3) Ci) ; Evans v. Commissioner, T.C. Memo. 1982-623; Announcement 75-39, 1975-17 I.R.B. 23.

20/ Reg. Section 1.1034-1(c) (3) Ci) . See pre- 1997 Act Code Section

1034(f) for special rules regarding tenant-stockholders in cooperative housing corporations. Tenant-stockholder and cooperative housing corporation are defined in Code Section 216 Cb)

21/ See Rev. Rul. 55-37, 1955-1 C.B. 347.

22/ Mitchell v. United States, 79-2 U.S.T.C. para. 9667 CC.D. Cal.

1979); Rev. Rul. 55-37, 1955-1 C.B. 347; Rev. Rul. 54-583, 1954-2 C.B.

158; Davies v. Commissioner, 54 T.C. 170 C1970). See also MacBoyle

Lewis Testamentary Trust v. Commissioner, 83 T.C. 246 C 1984); Marcello v.

Commissioner, T.C. Memo. 1964-299, aff’d, 380 F.2d 499 C5th Cir. 1967),

cert. denied, 389 U.S. 1044 C1968)

23/ See Belin v. United States, 313 F. Supp. 715 (M.D. Pa. 1970)

24/ See Evans v. Commissioner, T.C. Memo. 1962-61.

25/ Hughes v. Commissioner, 54 T.C. 1049 C1970), aff’d, 450 F.2d 980 C4th Cir. 1971); O’Barr v. Commissioner, 44 T.C. 501 C1965); Rev. Rul. 56-420, 1956-2 C.B. 519.

26/ See also Bogley v. Commissioner, 263 F.2d 746 C4th Cir. 1959) Estate of Campbell v. Commissioner, T.C. Memo. 1964-83; Rev. Rul. 83-50,

1983-1 C.B. 41.

27/ See Thomas v. Commissioner, 92 T.C. 206 (1989); Bolaris v. Commissioner, 81 T.C. 840 (1983), aff’d, 776 F.2d 1428 C9th Cir. 1985); Clapham v. Commissioner, 63 T.C. 505 (1975), acq., 1979-2 C.B. 1; Aagard

v. Commissioner, 56 T.C. 191 C1971); Houlette v.

- 28 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

Commissioner, 48 T.C. 350 (1967); Trisko v. Commissioner, 29 T.C. 515 (1957), acq., 1959-1 C.B. 5.

28/ Note that at the time of this decision, the time period for non-recognition of gain under pre-1997 Act Code Section 1034(a) was a period beginning one year before and ending one year after the date of sale of the principal residence.

29/ Pre-1997 Act Code Section 1034 Ca); Reg. Section 1.1034-1(c) Cl). A taxpayer who did not replace the property within the replacement period had to file an amended return for the year of the sale of the old residence and had to recognize the entire gain on that sale. IRS Publication 523, Selling Your Home.

30/ Gelinas v. Commissioner, T.C. Memo. 1976-103, aff’d without

published opinion, 573 F.2d 1285 (1st Cir.), cert. denied, 439 U.S. 823

(1978); Elam v. Commissioner, 58 T.C. 238 (1972), aff’d per curiam, 477

F.2d 1333 (6th Cir. 1973)

31/ Bayley v. Commissioner, 35 T.C. 288 (1960), acq., 1961-2 C.B. 4. See also United States v. Sheahan, 323 F.2d 383 (5th Cir. 1963)

32/ Elam v. Commissioner, 58 T.C. 238 (1972), aff’d per curiam, 477 F.2d 1333 (6th Cir. 1973); Rev, Rul. 69-434, 1962-2 C.B. 163.

33/ Pre-1997 Act Code Section 1034(k); see also Rev. Rul. 71-495,

1971-2 C,B. 311.

34/ Pre-1997 Act Code Section 1034 Cc) (4); Reg. Section 1.1034-1 Cd).

35/ See Reg. Section 1.1034-lCd) C2), Example.

36/ Pre-1997 Act Code Section 1034 Cd) Cl); Reg. Section

1.1034-lCd) (1)

37/ Pre-1997 Act Code Section 1034 Cd) (2); Code Section 217 Cc) . See Ch, 44 for a discussion of the moving expense requirements set forth in Code Section 217.

38/ Reg. Section 1.1034-1(c) (4) Ci) ; see Rev. Rul. 59-229, 1959-2 C.B. 180.

39/ Reg. Section 1.1034-1(c) (4) (ii) ; as to what constitutes capital expenditures, see Code Section 263.

40/ See also Boesel v. Commissioner, 65 T.C. 378 (1975)

41/ Reg. Section 1.1034-1(g) Cl) ; Rev. Rul. 75-175, 1975-1 C.B.

256.

42/ Rev. Rul. 69-343, 1969-1 C.B. 305; see also Code Section

- 29 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

7508 Ca) Cl) (K)

43/ Pre-1997 Act Code Section 1034(a); Reg. Section 1.1034-1(a) and Reg. Section 1.1034-1(c).

44/ Reg. Section 1.1034-1(a) ; Reg. Section 1.1034-1(b) (4) ; Reg. Section 1.1034-1(b) (5)

45/ Reg. Section 1.1034-1(b) (3) ; Reg. Section 1.1034-1(b) (7) ; Rev. Rul. 78-147, 1978-1 C.B. 261; Rev. Rul. 55-90, 1955-1 C.B. 348.

46/ Pre-1997 Act Code Section 1034 Cc) (2); Reg. Section

1.1034-1(c) (4) Cii)

47/ See PLR 8548027.

48/ See Grace v. Commissioner, T.C. Memo. 1961-252, wherein the Tax Court allowed the taxpayer to apply pre-1997 Act Code Section 1034 in a situation where the taxpayer constructed his new residence so that he could drive around the back of the house and into the basement to unload his building tools and materials. The court distinguished this situation from one in which the trade or business itself is actually carried out in the residence.

49/ Code Section 1031 Ca) Cl) ; Rev. Rul. 59-229, 1959-2 C.B. 180. For a discussion of like-kind exchanges, see Ch. 89.

50/ See Code Section 1031 Cd)

51/ Reg. Section 1.1034-1(h) (2) Ciii). The statement had to indicate that the taxpayer elected to treat the disposition of the taxpayer’s old residence as a sale for purposes of pre- 1997 Act Code Section 1034. In addition, the statement had to set forth:

Cl) the basis of the old residence;

(2) the date of its disposition;

(3) the adjusted sales price of the old residence, if known; and

(4) the purchase price, date of purchase, and date of occupancy of

the new residence if it was acquired before making the election.

52/ Code Section 165(h). See Ch. 43 for a discussion of casualty losses.

53/ Code Section 1033 Ca) (2) CA). See also Allen v. Commissioner, T.C. Memo 1998-406, and Rev. Rul. 67-254, 1967-2 C.B. 269.

54/ Rev. Rul. 76-84, 1976-1 C.B. 219; Rev. Rul. 70-466, 1970-2 C.B.

165.

- 30 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

55/ Code Section 1033 Ca) (2) (B) ; Reg. Section l.l033Ca)-2Cc) (3). This two-year period is extended to four years for a presidentially declared disaster. Code Section 1033 Ch) Cl) (B).

56/ See Rev. Rul. 73-36, 1973-1 C.B. 372.

57/ Commissioner v, Tufts, 461 U.S. 300 (1983); Reg. Section

1.1001-2(a).

58/ See Section 80.4 for a discussion of pre-1997 Act Code Section

121 and the rules regarding a one-time exclusion of gain from sale of a principal residence by an individual who attained age 55.

59/ See Code Section 165 Cc)

60/ Reg. Section 1.1001-2 Ca) Cl) ; Reg. Section 1.1001-2 (a) (2) ; Reg. Section l.61-l2Cb) Cl).

61/ Rev. Rul. 80-249, 1980-2 C.B. 166; Rev. Rul. 53-75, 1953-1 C.B.

83, amplified by Rev. Rul. 56-396, 1956-2 C.B. 298, modified by Rev. Rul. 65-297, 1965-2 C.B. 152.

62/ Under Code Section 453 Cb) (1), an installment sale generally is defined as any disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.

63/ Code Section 453 Cc) ; Reg. Section lSA.453-lCb) (2) Ci).

64/ Code Section 453(c) ; Reg. Section 15A.453-lCb) (2) Ci).

65/ Reg. Section lSA.453-lCb) (2) (ii) ; see also Code Section 483 Code Sections 1271-1275.

66/ Rev. Rul. 65-155, 1965-1 C.B. 356; Rev. Rul. 53-75, 1953-1 C.B.

83, amplified by Rev. Rul. 56-396, 1956-2 C.B. 298, modified by Rev. Rul. 65-297, 1965-2 C.B. 152.

67/ Pre-1997 Act Code Section l034Cg); Reg. Section l.1034-lCf).

68/ Reg. Section 1.1034-1(f) Cl) . See Rev. Rul. 75-238, 1975-1 C.B.

257.

69/ Reg. Section 1.1034-1(f) . An exception was provided for the case of an individual who died after the date of the sale of the old residence and was married on the date of death. Former Code Section 1034 (g) . See also Rev. Rul. 74-250, 1974-1 C.B. 202.

70/ For a discussion of pre-1997 Act Code Section 1034 in the context of a divorce, see Section 80.3Co).

71/ Murphy v. Commissioner, 103 T.C. 111 C1994), acq., 1996-29

- 31 -

Gross Income and Adjustments Cc) 1999, Kleinrock Publishing

I.R.B. 4. Note that although the taxpayer in Murphy was jointly and severally liable under Code Section 6013 Cd) (3) for the tax attributable to his wife’s allocable one-half share of the realized gain, the Tax Court also held that the taxpayer was entitled to compute his gain on the sale on the jointly owned residence by taking into account only his one-half allocable share of the basis and net proceeds from the sale of the residence.

72/ Snowa v. Commissioner, T.C. Memo. 1995-336, rev’d, 123 F.3d 190 (4th Cir. 1997) ; IRS Publication 523, Selling Your Home.

73/ For a case in which a taxpayer recognized a large taxable gain that might have been reduced or avoided with advance tax planning, see Feldman v. Commissioner, T.C. Memo. 1996-132. Cf.

Kellogg v. Commissioner, T.C. Memo. 1986-549.

74/ Bolaris v. Commissioner, 776 F.2d 1428 (9th Cir. 1985), aff’g in part and rev’g in part 81 T.C. 840 (1983); Clapham v. Commissioner, 63 T.C. 505 (1975) . Those cases involved situations where the property was rented instead of sold after the taxpayers moved out because of facts and circumstances over which the taxpayers had no control.

�END OF SECTION�

- 32 -

Rev. Rul. 76-541, 1976-2 C.B. 246 Cc) 1999, Kleinrock Publishing

Code Sec. 1034

�FULL TEXT�

26 CFR 1.1034-1: Sale or exchange of residence.

Residence and contiguous land sold separately; nonrecognition of gain. The nonrecognition of gain provisions of section 1034 of the Code will apply to gains realized by a taxpayer on the separate sale of a house situated on a parcel of land and the sale of a contiguous parcel later in the same year, both parcels of land having been used as the taxpayer’s principal residence, and the construction in the same year of a new principal residence whose cost exceeded the total adjusted sales price of the combined properties; Rev. Rul. 56-420 distinguished.

REV. RUL. 76-541

Advice has been requested whether, under the circumstances described below, the nonrecognition provisions of section 1034 of the Internal Revenue Code of 1954 apply to the gain realized from the separate sale of land included in a parcel contiguous to a principal residence sold by an individual taxpayer.

The taxpayer owned and resided in a house situated on an undivided parcel of land containing 10 acres. The entire 10-acre parcel was used as a part of the taxpayer’s principal residence. In early 1975, the taxpayer sold the house and three acres of land immediately surrounding the house. The boundaries of the three acres were established by survey, but the 7-acre portion of the original parcel was not divided, The taxpayer also attempted to sell a part of the 7-acre portion along with the three acres, but such attempt was unsuccessful.

A few weeks after the sale, the taxpayer began construction of a house on the remaining 7-acre portion to be used as a new principal residence. The house was completed and occupied by the taxpayer in late 1976.

Prior to the end of 1975, the taxpayer sold two acres of the 7-acre parcel to another purchaser. At no time was any portion of the ten acres held by the taxpayer for investment or for use in a trade or business.

The taxpayer realized a gain from each of the sales transactions. The taxpayer combined the gain from the sale of the old residence and three acres of land with the gain from the sale of the two-acre parcel and treated all such gain as gain from the sale of the old residence. The cost of constructing the new residence exceeded the total adjusted sales price of the combined properties and the taxpayer applied the nonrecognition provisions of section 1034 of the Code to all gain realized from the sales.

-1-

Rev. Rul. 76-541, 1976-2 C.B, 246 Cc) 1999, Kleinrock Publishing

Section 1034 Ca) of the Code provides, in part, that if property used by the taxpayer as a principal residence is sold by the taxpayer, and within a period beginning 18 months before the date of such sale and ending 18 months after such date, property is purchased and used by the taxpayer as a principal residence, gain (if any) from such sale shall be recognized only to the extent that the taxpayer’s adjusted sales price of the old residence exceeds the taxpayer’s cost of purchasing the new residence.

Section 1034 Cc) (2) of the Code provides, in part, that a residence any part of which was constructed or reconstructed by the taxpayer shall be treated as purchased by the taxpayer.

Section 1034 Cc) CS) of the Code provides, in part, that in the case of a new residence the construction of which was commenced by the taxpayer before the expiration of 18 months after the date of the sale of the old residence, the period specified in section 1034 Ca) shall be treated as including a period of two years beginning with the date of the sale of the old residence.

In Bogley v. Commissioner, 263 F.2d 746 (4th Cir. 1959), reversing 30 T.C. 4S2 C1958), individual taxpayers acquired thirteen acres of land in 1939 and constructed a residence in which they lived until December 1, 19S0, when they moved into a new residence located several miles from the old residence. Prior to December 31, 19S0, the taxpayers sold the old residence and three acres of land. The remaining ten acres were sold in S-acre parcels in June and August of 19S1. The United States Court of Appeals reasoned that the thirteen acres intact were part of the taxpayers’ old residence and that the character of the remaining ten acres did not change. Thus, the Court held that the gain realized from the sale of the ten acres in June and August of 1951 was entitled to the benefit of the nonrecognition provisions of section 112(n) Cl) of the Internal Revenue Code of 1939 as added by section 318 Ca) of the Revenue Act of 19S1. However, since section 112 Cn) Cl) Cthe predecessor of section 1034 of the 19S4 Code) applied only with respect to residences sold after December 31, 19S0, the taxpayers were required to report gain and pay capital gain tax attributable to the sale of the house and three acres.

In the instant case, before the sale of the 3-acre portion, the original parcel of 10 acres was the taxpayer’s "old principal residence." As in Bogley, the fact that the taxpayer sold the 3-acre portion of the property on which the house was located prior to selling the two acres of the remaining seven acres of land does not alter the character of the two acres. The 2-acre portion remains part of the taxpayer’s "old principal residence" for the length of the replacement period, despite the fact that the taxpayer constructed and occupied a "new principal residence" on the adjacent five acres.

Since the new principal residence was constructed rather than purchased, under section 1034 Cc) CS) of the Code the taxpayer’s replacement period is two years beginning with the date of the sale of the 3-acre parcel of land containing the taxpayer’s old principal residence. The subsequent separate sale of the 2-acre parcel of land does not cause a new

Rev, Rul. 76-S41, 1976-2 C.B. 246 Cc) 1999, Kleinrock Publishing

replacement period to begin.

Accordingly, the nonrecognition provisions of section 1034 of the Code apply to the gain realized from the sale of the 3-acre parcel of land containing the taxpayer’s house, and also to the gain realized from the separate sale of the 2-acre parcel of land.

Rev. Rul. S6-420, 1956-2 C.B. 519, is distinguishable. That Revenue Ruling holds, in part, that the benefits of section 1034 Ca) of the Code are inapplicable to the sale of a portion of a city lot on which a taxpayer’s house was located since the property sold did not include the taxpayer’s dwelling. The taxpayer did not purchase a new house but rather continued to reside in the old house.

�END RULING�

-3-