The IRS issued a private letter ruling to a taxpayer dealing with both the exclusion of gain on the sale of a residence under IRC §121 and the like-kind exchange provisions of IRC §1031 in PLR 201944006.[1]

The ruling involves a piece of property.

• One of the taxpayers had purchased the property to use as a principal residence, and when the taxpayers were married they continued to use it as their principal residence.  Eventually the taxpayers moved into a new residence.

• The property was then offered to rent.  While there was a period of time when the property was rented to full-time tenants, they also rented it for short-term rentals during other portions of this period of time.  The rental use ended when the property was destroyed in a fire.

• Following the fire the taxpayers received funds for the destroyed residence, sold the land without rebuilding the residence and acquired new property in a transaction they hoped would qualify for deferral of gain under IRC §1031.[2]

The taxpayers in PLR 201628002 were asking for the ability to use the reduced exclusion of a gain from the sale of principal residence under IRC §121(c)(2)(B)’s “unforeseen circumstance” provision due to the birth of a second child.

IRC §121 provides that taxpayers may exclude up to $250,000 ($500,000 for married taxpayers filing a joint return) of gain on the sale of a home if the property was owned by them for at least 2 of the past 5 years and also was used by them for 2 of the past 5 years (though the periods do not necessarily have to be the same days). The “2 of the last 5 years” test are applied as of the date of the sale. The provision also limits a taxpayer generally to claiming the exclusion only once every two years. [IRC §121(b)]

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

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