Anyone who has been following Elena Kagan’s confirmation hearings is up to speed on the judicial activism/strict construction debate. Strict construction of an exclusion from taxable income powered a notable win for the IRS in Gates v. Comm’r, 135 T.C. 1 (July 1, 2010), a very interesting income tax case that will have implications for private clients at all wealth levels. Gates involved Section 121, which allows exclusion of gain from the sale of property owned and used by the taxpayer as the taxpayer’s principal residence for two of the five years preceding the sale. (The excludible amount of gain is $250,000 for single filers and $500,000 for a husband and wife who file a joint return.)
Gates held that taxpayers who tore down their house (after living in it for at least two of the five years before it was torn down), and then built a replacement house on the same land, but sold the new house without living in it, could not exclude their capital gain on the sale from their taxable income.
In this case, Mr. Gates had purchased a modest 880 square foot residence in 1984 in California for $150,000. In 1989, Mr. Gates married Mrs. Gates, and the couple lived in the house for at least two years from August 1996 to August 1998. In 1996 the petitioners decided to enlarge and remodel their house, and hired an architect. After reviewing building and permit restrictions enacted since the original house was built, they demolished their original house and built a new three-bedroom house on the property.
The Tax Court’s opinion noted that:
The footprint of the new house has a very different shape from that of the original house, and it appears to be two to three times larger than the footprint of the original house. Only about one-half of the land area of the original house overlaps with the land area covered by the new house, and no part of the original foundation perimeter corresponds to the foundation perimeter of the new house.
In April, 2000 Petitioners sold the new house for $1.1 million. At the time of the sale, petitioners had never resided in the new house. The record shows that the sale resulted in a $591,406 gain to petitioners. On a 2000 return that was not timely filed, the petitioners excluded all of this capital gain from their income. They later agreed that at least $91,406 of the capital gain should have been taken into 2000 gross income, but argued that the remaining $500,000 gain was excludible from their income under Section 121. The IRS sent a notice of deficiency in 2005, increasing petitioners’ 2000 income by $500,000 and claiming that petitioners had failed to establish that any gain on the sale of the property was excludible under Section 121.
The Tax Court explained its statutory construction task for Section 121 as follows:
The issue presented arises from the fact that section 121(a) does not define two critical terms–“property” and “principal residence”. Section 121(a) simply provides that gross income does not include gain from the sale or exchange of property if “such property” has been owned and used by the taxpayer “as the taxpayer’s principal residence” for the required statutory period.
The IRS argued that “petitioners did not sell property they had owned and used as their principal residence for the required statutory period because they never occupied the new house as their principal residence before they sold it,” because the term “property” meant a “dwelling that was owned and occupied by the taxpayer as his “principal residence” for at least 2 of the 5 years immediately preceding the sale.”
The taxpayers argued that the Section 121(a) exclusion applies to gain on the sale of property that was used as the taxpayers’ principal residence, and focused on two facts. First, they had used the original house as their principal residence for the required period. Second, they had sold the land on which the original house had been situated. The taxpayers argued that the “term ’property’ includes not only the dwelling but also the land on which the dwelling is situated,” and that they could satisfy Section 121′s requirements by living “in any dwelling on the property for the required 2-year period even if that dwelling is not the dwelling that is sold.”
Because Section 121 does not define the terms “property” and “principal residence”, the Tax Court undertook a statutory construction exercise, reviewing the plain meaning of the terms and legislative history dating as far back as 1951. Based on this review, the Tax Court concluded that:
The legislative history demonstrates that Congress intended the term “principal residence” to mean the primary dwelling or house that a taxpayer occupied as his principal residence. Nothing in the legislative history indicates that Congress intended section 121 to exclude gain on the sale of property that does not include a house or other structure used by the taxpayer as his principal place of abode. Although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that Congress intended the section 121 exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a).
Of course, once the Tax Court reached this conclusion, it became pretty clear that this opinion would be bad news for Mr. and Mrs. Gates, and for other taxpayers not excited about historic preservation. The Tax Court might even have felt sorry for Mr. and Mrs. Gates, but it had a job to do:
Although we recognize that petitioners would have satisfied the requirements under section 121 had they sold or exchanged the original house instead of tearing it down, we must apply the statute as written by Congress. Rules of statutory construction require that we narrowly construe exclusions from income. Comm’r v. Schleier, 515 U.S. at 328. Under section 121(a) and its legislative history, we cannot conclude on the facts of this case that petitioners sold their principal residence. Accordingly, we hold that petitioners may not exclude from income under section 121(a) the gain realized on the sale of the … property.
Readers may immediately spot some problems with the Tax Court’s decision. If Gates is taken for the proposition that there is no “tacking” on the 2-of-5-year Section 121 requirement for a teardown, but that there is for renovations, what about the predictable line-drawing problems in defining where renovation ends and teardown begins? These sorts of problems were highlighted in a dissent from Judge Halpern: “The majority’s report will undoubtedly raise … remodeling versus rebuilding questions…. I think that the better course would be to avoid provoking those questions.”
The dissent (in which Judge Mark Holmes, previously featured in KYEstates, joined) advanced its argument with a sympathetic hypothetical (e.g., hurricanes in Florida — tornadoes in Kentucky?):
…consider a taxpayer whose longtime home is demolished by a natural disaster (a hurricane). The taxpayer lacks insurance. Nevertheless, she rebuilds on the same land (perhaps a bit further from the ocean) and lives in the rebuilt house for 18 months, and then she sells the house and land at a gain. Although the taxpayer satisfies the property use condition, I assume that, nevertheless, under the majority’s analysis, she gets no exclusion because she fails the temporal condition; i.e., she has not lived in the rebuilt house for 2 or more of the last 5 years. I assume further that, if her house had been only damaged (and not demolished), and she repaired it, she would get an exclusion. That seems like an untenable distinction to me.
Judge Cohen wrote a concurrence to the majority opinion, and rebutted the dissent’s “future consequences” line of argument:
The dissent objects to the result and argues that the majority’s analysis in this case will distort the result in other cases in which the taxpayer should qualify for the section 121 exclusion. The response to this argument is straightforward–it is not this Court’s job to anticipate and decide cases that are not yet before it. We may reach a different conclusion in cases involving different facts if and when the opportunity arises, but we should not distort the result in this case by anticipating those cases.
The dissent, however, didn’t believe this much judicial restraint was advisable:
It is no answer to that criticism to say, as Judge Cohen does, that it is not the Court’s job to anticipate and decide cases that are not yet before it. We are a national court that treats its own cases as precedent until we overrule ourselves by action of the Court Conference. This case (and my arguments) have been before the Court Conference. We should recognize, as no doubt the Commissioner and taxpayers will, the weight that the analysis in this case will carry in similar situations under principles of stare decisis.
Because the dissent didn’t carry the day, Gates has immediate consequences for private clients throughout the United States who tear down their houses, and build new homes on their property. After Gates, if a job change, family illness, or other unpredictable event requires the homeowner to move within two years of building the new house, the Section 121 capital gain exclusion is jeopardized. This means that any demolition decision should incorporate an assessment of capital gains tax risk. Attorneys, trust officers, wealth managers, and accountants who work with any clients tearing down a home – please warn them about Gates.
Thanks to KYEstates reader Chris Staples of PNC Wealth Management in Louisville for alerting us to this significant and interesting case.