This article is a reprint from the July, 1990 issue of the Journal of Taxation, a publication of Warren, Gorham and Lamont.
By Robert L. Sommers
For many taxpayers, their principal residence represents their most valuable asset. Over the past 20 years, housing prices have risen dramatically, especially along the East Coast and in California. For a variety of reasons, taxpayers may now desire to "trade-down" their principal residences. But with the elimination of the capital gains deduction brought by the Tax Reform Act of 1986, such a sale could trigger a huge tax, particularly where the gain has been deferred over a number of years by the rollover provisions of Section 1034.
This article discusses the operation of Section 1034, the provision that permits the tax-free rollover of a principal residence; Section 121, the once-in-a-lifetime election to exclude as much as $125,000 of taxable gain upon the sale of a principal residence; and the various tax planning techniques available when a taxpayer desires to "down-size" the value of a principal residence.
Taxpayers who want to purchase a smaller retirement home or those who are moving to a less expensive part of the country may want to purchase a replacement residence that costs substantially less than the current value of their current residence. Under the tax law, a principal residence is considered a personal asset and is not eligible for tax-free exchange treatment under Section 1031. Section 1034, however, is beneficial only when the taxpayer is "trading-up" residences: i.e., purchasing a replacement residence that is equal to or greater in value than the present residence. And Section 121 is limited in scope and, because of inflation, its $125,000 dollar limitation may be insufficient to protect against the substantial taxable gain that may arise from the sale of a principal residence.
The main code section involved with the sale or exchange of a principal residence is Section 1034.1 A taxpayer is permitted to sell or exchange his residence (hereafter "old residence") µ provided that residence was used as his principal residence µ for another principal residence (hereafter "new residence") and defer some or all of the gain which would have been taxable, absent Section 1034. In general, if a taxpayer acquires a new residence that is used as a principal residence and that is equal to or greater in cost than the adjusted sales price2 of the old residence, there will be no gain or loss recognized. If the new residence costs less than the adjusted sales price of the old residence, then the gain will be recognized to the extent of the difference. The new residence must be acquired within 2 years from the date the old residence is sold (hereafter the "statutory period").3 Section 1034 is mandatory: Taxpayers cannot elect its treatment although they may plan around its operation by purchasing a new residence either more than 2 years before or after the sale of the old residence.
In addition to the traditional single family dwelling, a condominium, houseboat, house trailer, or stock in a cooperative housing corporation can qualify as a principal residence.4 A principal residence does not include personal items unless those items are considered fixtures under local law.5
If two or more unrelated taxpayers own a residence and use it as their principal residence, Section 1034 will apply to the interest of each taxpayer in the residence.6 Two taxpayers can combine forces, sell their respective principal residences and then purchase a single new residence jointly under Section 1034.7 A grantor trust that owns the principal residence of its beneficiary is eligible to use Section 1034.8 A non-grantor trust that owns a principal residence is ineligible to use Section 1034; use of a principal residence by the beneficiary will not be attributed to the trust. The concept of a principal residence would generally exclude ownership by a corporation, trust or estate, but a partnership should be able to claim the benefits of Section 1034 if the ownership is attributed to the individual partner.
Section 1034 applies even if the location of the old or new residence, or both, are located outside the United States9 and there are no restrictions as to citizenship or residence of the taxpayer. 10 Under Section 1034(k), a taxpayer whose tax home (as defined in Section 911 (d)(3)) is outside the United States may suspend the time period to purchase a replacement residence as long as 4 years after the sale date of the old residence.
Special rules under Section 1034(h) apply to taxpayers who are on active duty in excess of 90 days or for an indefinite period with the U.S. Armed Forces. The time limitation to purchase a new residence is generally 4 years from the sale date of the old residence, but for taxpayers stationed outside the United States in an area with inadequate off-base housing, the time period may be extended for 8 years.
To prevent taxpayers from utilizing Sec 1034 to sell residences in rapid succession, Section 1034 will apply only to one sale and purchase during the statutory period. In such circumstances, there are 3 rules that limit the applicability of Section 1034:
There is an exception to the rules of Section 1034 (c)(4) and Section 1034(d)(1) if the subsequent moves are caused by a taxpayer relocating to a new work place. Thus, where a taxpayer sold his principal residence and purchased a new residence in a different state in connection with his job µ then moved to a different state 16 months later and purchased another house there µ the subsequent sale of the first replacement residence qualifies under Section 1034(d)(2).11
A taxpayer may have only one principal residence at a time. If the taxpayer owns two or more residences, the principal residence will be the one in which he lives the majority of time.12 In order for a residence to qualify as a new residence, the taxpayer must physically occupy the property no longer than 2 years from the date of sale of the old residence. Token use of a new residence will not suffice; the taxpayer must actually live in the residence as a principal residence13; occupation by the taxpayer's children is insufficient.14 The 2-year deadline is unforgiving: A taxpayer was denied Section 1034 treatment because he failed to occupy his new residence within the 2-year deadline despite making every effort to complete the building of a new residence and move into it.15 This rule has even been applied to prevent a former president from using Section 1034 when he intended to make his new residence a permanent residence after leaving the White House.16The IRS has ruled that even if the new residence is destroyed by fire, thus preventing the taxpayers from physically occupying the new residence within the statutory period, Section 1034 would not apply.17
A taxpayer is not required to physically live in the old residence prior to sale; indeed, the statutory scheme allows the purchase of a new residence up to 2 years before the sale of the old residence. So long as the taxpayer is attempting to sell the old residence, renting the old residence prior to sale does not invalidate Section 1034 and may provide for certain business deductions as well. 18
To determine whether any gain is recognized under Section 1034, the cost of the new residence is compared with the adjusted sales price of the old residence. The cost of the new residence is the combination of the purchase price plus any improvements made to the new residence during the 4-year statutory period.19
The seller who acquires a new residence must acquire it in his own name. When a taxpayer sold a principal residence and purchased a replacement residence in the name of the taxpayer's mother, nonrecognition treatment under Section 1034 was denied.20 Nonrecognition of gain under Section 1034 may still apply, however, when a new residence is acquired in the name of a spouse, as opposed to a parent or child, since a husband and wife may be treated as one taxpayer under Section 1034(g), if they consent to this treatment. If one of the spouses dies before consenting under Section 1034(g), the surviving spouse may consent for both of them.
Section 1034 shares many of the characteristics of other nonrecognition provisions: The taxpayer merely defers the gain until he engages in a taxable transaction and the taxpayer uses the carryover basis rules of Section 1012. Therefore, the basis in the new residence is reduced by the amount of gain deferred µ thus preserving the gain inherent in the property until it is sold or otherwise disposed of in a taxable transaction.
Section 1034 is similar to Section 1033 (the statute that governs the replacement of condemned property) in that a taxpayer may actually receive cash-in-hand without having to recognize gain. If the old residence is condemned or is sold under threat of condemnation, the taxpayer may elect to have Section 1034 apply instead of Section 1033.21
Section 1034, however, is much narrower in its reach than other nonrecognition provisions in the code: The sale and purchase must both be principal residences; there is generally a 2-year period for the sale and purchase; generally there can be no more than 1 purchase and sale within a 4-year period; and, most importantly, gain is deferred to the extent that the cost of the replacement residence is equal to or greater than the adjusted sales price 22 of the old residence.
In other words, to use Section 1034 to defer gain, the taxpayer must constantly "trade-up" residences.23 The comparison is between the selling price of the old residence and the cost of the new residence. The basis of the old residence and the amount of liabilities of the old residence are irrelevant to the issue of gain recognition. Under Section 1034(c), the basis in the new residence consists of the basis of the old residence together with the cost of any construction, reconstruction and improvements made to the new residence during the period ending 2-years after the old residence is sold.
Under Section 121(a), a taxpayer who reaches the age of 55 may elect to exclude from gross income the gain from the sale or exchange 24 of his principal residence, to a maximum of $125,000 ($62,500 in the case of a married individual filing separately). This election may be made only once and applies to a principal residence that the taxpayer has owned and used as such for an aggregate of 3 years out of the 5 years immediately preceding the sale of the house. In a recent change, Section 121(d)(9) was added to permit a taxpayer living in a licensed out-of-residence care facility, due to physical or mental inability for self-care, to use Section 121(d) if the taxpayer lived in the principal residence an aggregate of 1 year out of the preceding 5 years. Under the regulations, the 3-year test may be met by establishing ownership and use aggregating 36 full-months or 1,095 days (365 x 3).25 Temporary absences from the principal residence, such as vacations or other seasonal absences, even if the residence is rented during the absences, are considered periods of use.
Section 121 will apply to the reacquisition of a principal residence by the taxpayer in partial or full satisfaction of the indebtedness arising from the sale of the property, provided the principal residence is resold within 1 year after the date of reacquisition. 26
In contrast to Section 1034, the residence does not need to be a principal residence on the date of sale under Section 121; the taxpayer only needs to establish that the residence was a principal residence for 3 of the last 5 years.27 Therefore, if a residence meeting the requirement of Section 121 is converted into income producing property and is then exchanged under Section 1031, both Section 121 and Section 1031 should apply to exchange. Therefore, the taxpayer could receive as much as $125,000 in tax-free boot in the Section 1031 transaction. Under these circumstances, however, Section 1034 would not apply, so the taxpayer could not exchange the residence for both Section 1031 property and Section 1034 property since the residence would not qualify as an old residence for Section 1034 purposes.28
A husband and wife may only make the election once: Therefore, if one spouse made the election prior to marriage, the other spouse is prevented from making the election.29 For example, if prior to marriage, a man and woman each owned a residence eligible for the Section 121 election, once they married the election could apply to either house but not both. One of the parties could sell his or her residence prior to marriage and the other party could still elect Section 121 after the date of the marriage.30 Conversely, under Section 121(d)(1) if a couple owns a residence, the election is available to a married couple filing jointly even if only 1 of the parties meets the eligibility requirements.
The sale of a life interest qualifies for the Section 121 exclusion if that is all the seller owns. According to the IRS, where the taxpayer sells his residence and retains the right to live in the residence tax-free for the remainder of his life, there has been a sale of the remainder interest only and the transaction does not qualify under Section 121.31 This result could be avoided through a bona fide sale lease-back situation where the taxpayer actually disposes of his entire interest in the property and then leases back the residence at fair market value.32 A grantor trust that owns the principal residence of its beneficiary is eligible to use Section 121.33 But a principal residence or portion thereof placed in a trust for a surviving spouse, in which the surviving spouse has a life interest, will not qualify for the election under Section 121.34 Under Section 121(d)(2), if a deceased spouse met the holding and use requirements of Section 121 and if there has not been an election with respect to a prior property, the surviving spouse is permitted to tack the deceased spouse's holding and use requirements for purposes of making the election.
The easiest solution to down-sizing a principal residence is to sell the old residence, use the Section 121 exclusion for the full $125,000 and then purchase a replacement residence for $125,000 less than the adjusted sales price of the old residence. For instance, the sale of an old residence whose adjusted sales price is $500,000 (assume a basis of $100,000) and the purchase of a new residence for $375,000 results in a non-taxable transaction. Section 121 would apply to the first $125,000 in gain realized and Section 1034 would defer the remaining $275,000 of gain. If, however, Section 121 is not available or if the adjusted sales price of the old residence is greater than $125,000 of the cost of the new residence, then other tax-planning options must be explored to retain a tax-free transaction.
One solution to down-sizing a principal residence is to converting a portion of the principal residence into an asset eligible for the nonrecognition provisions under Section 1031.35 In Revenue Ruling 57-244,36 the Service ruled that property originally acquired for use as a principal residence may be converted into Section 1031 property if the taxpayer abandons his intent to use the property for personal use and decides to use it as investment property.37 The focus of the courts has been whether, in substance, the taxpayer has abandoned his original intent for the intent he now is claiming. The courts have held that despite vacating a residence and even renting it out while it is on the market, the taxpayer has not abandoned his original intent of treating the property as a principal residence. 38 Where the taxpayer, however, abandons his principal residence and uses another property as a principal residence µ despite using the abandoned residence on weekends µ Section 1034 will not apply to the abandoned residence.39 Section 1034 can be avoided by abandoning a residence as the principal residence, either through using another residence as a principal residence or renting out the residence as a long-term investment. If, however, the taxpayer sells his residence within the statutory period, the issue arises as to whether the taxpayer truly abandoned the residence or whether he retained his original intent of treating the residence as a principal residence.
Section 1031 only applies when a taxpayer exchanges investment property for "like-kind" property which will continue to be held as investment property; investment property exchanged for like-kind property held for personal use results in a taxable transaction. When a taxpayer receives property in a Section 1031 exchange and then uses that property for personal purposes (by gifting it to his children or using it as a principal residence), the main concern is whether the taxpayer held the property received in a Section 1031 exchange as investment property prior to its conversion.
Unfortunately, under Section 1031 there is no specified time limit during which the property must continue to be held as investment property before it can be converted into personal use property such as a principal residence.40 At issue is whether it was the taxpayer's intent to convert the property from investment property to personal property at the time the Section 1031 exchange occurred. In Wagensen v Cm.,41 the taxpayer exchanged one ranch for another under Section 1031 and 9 months later gifted the recently acquired ranch land to his children. The Tax Court held that there had been a valid Section 1031 exchange and rejected the IRS's position that no tax-free exchange occurred because the taxpayer never had the intent to hold the acquired ranch as an investment. The court noted that at the time of the exchange, the taxpayer had no concrete plans to convey the property to his children and that the taxpayer continued to run the acquired ranch as a ranch until the gift occurred.
In Click v Cm., on facts similar to those in Wagensen , the taxpayer, pursuant to Section 1031, exchanged a farm for two residential properties, cash and a note. On the same day, the taxpayer's two children and their families each moved into the residences. Seven months later, the taxpayer made a gift of the two residences to her children. The Tax Court held this violated Section 1031's requirement that the property received must be held for investment. The court found the taxpayer had contemplated making a gift of the property at the time of the exchange since one child lived in 1 of the properties rent-free during the 7 months prior to receiving it as a gift, and the other child paid for the property taxes and insurance on the property she eventually received as a gift. The properties received in the Section 1031 exchange were inspected only by the donees. On these facts, the court had no trouble finding the taxpayer's intent at the time of the exchange was to make a gift of the properties to her children, not to hold the properties for investment as required under Section 1031.
In order to comply with Section 1031, there should be no concrete plans to convert investment property into a principal residence at the time of the exchange, and the property received should be rented out with the taxpayer continuing to pay the expenses on the property prior to any conversion.
One way to down-size a principal residence prior to its sale is to convert a portion of it to business or investment use, thereby qualifying that portion for Section 1031 treatment. The regulations under Section 1034 state that "only that part of the gain allocable to the residential portion is not to be recognized under this section..."; therefore, the residence is bifurcated and the sale is treated as 2 separate transactions with only that part of the residence used as a principal residence qualifying under Section 1034. The principal residence is then exchanged (not sold) for either:
The objective is to end up with the same proportion of personal and investment use in the new residence (or new residence and other properties) as was present in the old residence.
If a portion of the principal residence is:
that portion will be excluded from Section 1034.42 Even where a taxpayer does not claim any deductions for the business use of a residence, whether or not a residence is in fact used partly for business is a factual question.43 The Service has recognized that if a residence is exchanged for another residence, Section 1034 would apply to the personal residence portion of the exchange and Section 1031 would apply to the business use portion of the exchange.44 Also, Section 1034(c)(1) expressly provides for an exchange of a principal residence for another principal residence to be treated as a sale and purchase for purposes of Section 1034.
The transaction should be structured under Section 1031 since Section 1034 permits the exchange of a residence. Unlike Section 1034, Section 1031(b) treats the receipt of cash as taxable "boot" and Section 1031(a)(3) requires that nonsimultaneous exchanges occur under much more stringent time limits.45
Once the requirements of Section 1031 are satisfied, Section 1034 should continue to apply to the personal residence portion of the acquired property. For instance, under Section 1034(c)(2), construction, reconstruction and improvements made to the principal residence within two years after the sale of the old residence should increase the basis of the residence for purposes of determining the gain. Since the old residence's sale will be considered two separate transactions (a portion qualifying under Section 1031 and a portion qualifying under Section 1034), the receipt of nonqualifying Section 1031 boot (cash or other property) should be allocated to the Section 1031 and Section 1034 portions on a percentage basis. For example, if 1/3 of the residence is used for business and 2/3 is used as a principal residence, then the receipt of $1,200 in cash should be treated as follows: $400 of taxable boot under Section 1031(b) and $800 under Section 1034.
There are many cases under Section 1034 involving multiple use residences, residences where there has been some business use in addition to use as a principal residence. Most cases involved taxpayers claiming the business use portion belonged under the nonrecognition benefits of Section 1034 while the government contending the sale of the business use portion of the property constituted a taxable transaction. The government has indicated that taxpayers who previously claimed a portion of their residence for business use would not be allowed to use Section 1034 to defer that portion on a subsequent sale.46
Section 280A polices the use of a residence for business purposes. In general, Section 280A provides that a taxpayer may be entitled to a deduction for use of a residence if a portion of the residence is exclusively used on a regular basis in taxpayer's trade or business as a:
The deduction is limited to the gross income of the business reduced first by all business expenses that are not allocable to the use of the residence.
Initially, the IRS took the position that a taxpayer could be denied Section 1034 treatment for that portion of a principal residence claimed as use in a trade or business under Section 280A even though the deductions under Section 280A were disallowed. 47 In 1982, however, the government issued Revenue Ruling 82-2648 which for all practical purposes allowed the taxpayer to reconvert the business-use portion of the property into a principal residence at his election. The Revenue Ruling 82-26 states that if in the year of sale, the business-use of the property would not meet the requirements of Section 280A for deductibility, then the entire property would be considered a residence under Section 1034.49
This Revenue Ruling 82-26 is extremely helpful in those situations where a taxpayer is selling multiple-use residences and wants to use Section 1034 to trade-up a residence µ rollover the entire amount of the proceeds into a new residence to be used exclusively as a principal residence. And Section 1031 will assist the taxpayer who wants to achieve the opposite result: exchanging the old residence for a less expensive new residence and some investment property or properties.50 If the taxpayer is receiving more than one property, then one property needs to qualify as a principal residence and the other property or properties need to qualify under Section 1031.
A taxpayer who qualifies under Section 280A as using a portion of his principal residence for business should be able to trade-up or trade-down his principal residence on a tax-free basis. Fortrade-ups, merely failing to comply with Section 280A in the year of sale will suffice under Revenue Ruling 82-26 to have the entire sale qualify under Section 1034; for trade-downs, use of Section 1034 for the principal residence portion and use of Section 1031 for the Section 280A business portion will result in tax-free treatment.
Oftentimes a residence has multiple uses such as an office in the home that meets the Section 280A requirements51 or a separate rental unit that is rented to a tenant. But once the residence is in the process of being sold, it will generally retain its character as personal property, despite efforts to deduct business expenses associated with the rental activity.
In Newcombe v Cm.,52 the taxpayer moved out of his principal residence and immediately tried to sell it. The taxpayer claimed business deductions under Section 167(2) and 212(2) during the period the house was on the market. The Tax Court rejected the taxpayer's claim for the deductions, finding that the residence remained personal in nature and was not converted into business property by virtue of the attempted sale.
The court held that for a taxpayer to convert a personal residence into property held for investment under Reg 1.212-1(b) the taxpayer must seek to realize a profit representing postconversion appreciation in value. The court found that placing the property on the market for immediate sale will ordinarily be strong evidence that the taxpayer is not holding the property for investment (the postconversion appropriation in value). Notably, the court said:
... if a taxpayer believed that the value of the property may appreciate and decided to hold it for some period in order to realize upon such anticipated appreciation, as well as an excess over his investment, it can be said that the property is being 'held for the productions of income.' And this would be true regardless of whether his expectation of gain was reasonable.53
In Bolaris v Cm.54, the Ninth Circuit held that a taxpayer who rented out his residence prior to selling it was entitled to both nonrecognition treatment under Section 1034 as well as deductions for the expenses incurred in the rental activity under Sections 167 and 212. The court held that a residence could be entitled to rental expense deductions even though the congressional history to Section 1034 stated:
the term, 'residence' is used in contradistinction to property used in a trade or business and property held for the production of income.
Unlike Newcombe, the taxpayer in Bolaris actually rented out his residence for a period of time. The Bolaris case is useful to taxpayers who want to utilize Section 1034 and also deduct expenses incurred under Sections 167 and 212 for renting out their principal residence in an effort to sell it.
The language in the Newcombe case is helpful in determining how a residence is transformed into investment property. The key factor is whether the taxpayer held the property for postconversion appreciation in value. A taxpayer whose principal residence is part of a larger parcel of land might use the rationale in Newcombe to rezone or subdivide the land and sell the principal residence under Section 1034, and to retain the surrounding acreage and hold it for investment.55
The difficulty with this approach is the tendency of the IRS to hold that surrounding acreage of a principal residence retains its character as part of the principal residence, despite a later sale of the separate property.56 One way to avoid the regrouping of the separate exchange as part of the sale of a principal residence would be to convert the property's character into business use and then exchange it at least 2 years prior to or after the sale of the old residence since Section 1034 by its terms only applies if there is a sale or exchange of a principal residence and an acquisition of a replacement residence within two years of each other. Another approach is to build a structure on the surrounding land and sell it along with the vacant property. Or, if the property is located in a rural area, use the surrounding land in some type of income-producing activity such as farming, raising livestock, harvesting timber, mining natural resources or leasing it to others.
If the IRS is successful in recharacterizing the property as part of a Section 1034 transaction, then the fair market value of the property transferred under the failed Section 1031 transaction will be counted as part of the adjusted sales price of the old residence. Taxable gain will arise if the replacement residence costs less than the old residence's adjusted sales price.
Because of the elimination of the capital gains deduction, together with a historically lower rate of taxation on interest payments, taxpayers should consider using the installment sales rules under Section 453 for the sale of old residence, especially where the new residence will cost less than the old residence's adjusted sale price.
An installment sale involves the disposition of property where at least 1 payment is received after the close of the tax year in which the disposition occurs.57 An installment sale of a principal residence involves the seller receiving the purchaser's obligation for future payments as all or part of the consideration paid. Unless the seller decides to elect out of installment sales treatment, gain is reported as received ratably over the period of the installment obligation.
The following example illustrates the theory behind use of the installment sales method: Assume the taxpayer will have $1,000 of gain on the sale of property (with no adjusted basis) and will invest the proceeds for 5 years with a return of 10% per year. If the taxpayer sells the property and receives the cash, the after-tax amount for investment purposes will be $680.58 If that cash is invested at 10% per annum, the return will be $68 per year. Under the installment sales method, assuming the taxpayer receives the full amount of principal in year 5, there is no tax on the principal until year 5 and at 10% per year, the taxpayer will receive $100 per year.59 The taxpayer is using the tax dollars that would have been paid to the government as an income-producing asset to generate interest income. Furthermore, under the Tax Reform Act of 1986, the interest income is taxed at a maximum federal rate of 33%,60 the lowest maximum rate for ordinary income in many years, while delaying the payment of capital gains which is currently taxed at one of the highest rates ever.61
There may be drawbacks to the installment sales method such as state law restrictions on seller-financed real estate obligations. 62 There is also a major estate planning concern: an installment note is considered "income in respect to a decedent" under Section 691 and, upon the death of the taxpayer, there will be no step-up in basis under Section 1014(c).63
The installment sales method of accounting is one of the most complex and politically charged provisions in the tax code.64 The installment sales provisions attempt to allow a taxpayer, who sells property and then receives payments over time (in installments), to report the gain when the payments are received. The payments are divided into 3 main components: gain, return of basis and interest. For installment sales purposes, the interest is treated separately; it is the principal payment that is divided into gain and return of basis components.
As illustrated by the formula below, the installment sales method of accounting takes the "installment payment received" and multiplies it by a fraction consisting of the "gross profit" as the numerator and the "total contract price" (including the costs of sale) as the denominator.
installment payment received X gross profit
total contract price
Amounts excluded from taxation or are currently non-taxable reduce the gross profit (numerator). The critical issue is whether those amounts are included as part of the installment payments received and as part of the total contract price, or whether those amounts are excluded from the installment payments received, the gross profit (numerator) and the total contract price (denominator) µ thereby excluding those payments from the installment sales calculation completely.
The relationship between the installment sales rules and Sections 1034 and 121 is defined in a trilogy of revenue rulings. The first, Revenue Ruling 75,65 held the amount of gain deferred under Section 1034 (formerly Section 112) was eliminated from the gross profit numerator in the calculation of an installment sale, but still was included in the first year's payment and in the total contract price (denominator). Therefore, the deferral amount would be received over the life of the installment obligation.
The second, Revenue Ruling 65-155,66 applied Revenue Ruling 75 to the receipt of like-kind property under Section 1031 in conjunction with an installment sale. The ruling held the receipt of property was part of the first year's installment payment received. The amount of unrecognized gain was eliminated from the gross profit (numerator) but retained in the total contract price (denominator).
The third, Revenue Ruling 80-249,67 applied Revenue Ruling 75 and Revenue Ruling 65-155 to the situation involving the Section 121 exclusion and held that consistent with the above rulings, the exclusion amount is merely eliminated from the gross profit (numerator) but remains part of the total contract price (denominator). This means the excluded amount would be recovered over the life of the installment obligation.
These three revenue rulings, each one dependent on the prior ruling, formed a consistent basis for treatment of non-recognition payments under Sections 1031 and 1034, and payments qualifying for the exclusion under Section 121. These payments to be recovered ratably over the period of the installment obligation.
In 1980, however, Congress added Section 453(f) to the installment sales statute. This new provision eliminated from the installment payment received, gross profit (numerator) and total contract price (denominator) any like-kind property received under Section 1031. In the Congressional History to Section 453(f), Congress made it clear that it was legislatively reversing the holding in Revenue Ruling 65-155, the centerpiece of the trilogy that controlled the consequences of using an installment sale in conjunction with Section 1034 and 121. Congress also stated the basic purpose of the installment sales method was to recognize gain as cash (or other property with respect to which gain is recognized) is received.
The starting point for the installment sales method is the receipt of cash or property in which gain is recognized. By this definition, nonrecognition property and property excluded from the definition of gross income should be eliminated from the installment sales calculation. Indeed, under Section 1034, the receipt of cash on the sale of old residence is not the equivalent of receiving an installment payment in a taxable (gain recognition) transaction, its receipt is merely a temporary step in the tax-free acquisition of a new residence. Under Section 1034, the taxpayer is ultimately exchanging the old residence for a new residence. The transaction is similar to Section 1031 in this regard, and the analogy to Section 1031 µ for purposes of applying installment sale provisions of Section 453 µ is proper. When a taxpayer receives cash under Section 1034, that cash should be eliminated from the installment sales calculation completely because the taxpayer will either acquire a new residence which is a nonrecognition transaction or will fail to comply with Section 1034 which causes the cash received to be taxable. Therefore, cash received and used to purchase a new residence under Section 1034 is the functional equivalent of receiving nonrecognition property under Section 1031 and both should be eliminated from the installment sales calculation.
Although the treatment of consideration received under Section 1034 or Section 121 as part of an installment sale was not addressed in the legislative history or under Section 453(f), Revenue Ruling 75 and Revenue Ruling 80-249 should be considered invalid to the extent that they would produce a different result than would occur under Section 1031. In Prop. Reg. 1.453-1(f)(3)(i), the Treasury recognized that other nonrecognition transactions will qualify for the treatment accorded to Section 1031(b) transactions. Indeed, in Prop. Reg 1.453-1(f)(3)(iii), example 4, the Treasury specifically sanctions the use of the Section 453(f) rules to a Section 1034 rollover.68 Proposed regulation, however, apparently does not treat the receipt of cash from the sale of a residence the same way as the receipt of nonrecognition property under Section 1031.69
There is no mention in the Congressional History or in Section 453(f) of the treatment of payments excluded from gross income under Section 121, and the example in the proposed regulation excluded Section 121 from the fact pattern. Section 121 is an exclusion from gross income; therefore, the payments should circumvent the installment sales fraction altogether. In that regard, Revenue Ruling 80-255, basing its result on Revenue Ruling 65-155, was an incorrect interpretation of the law at its inception and, after the legislative reversal of Revenue Ruling 65-155, there is no legal foundation for concluding that any payments excludable under Section 121 must be recovered on a pro-rata basis under the installment sales method.
Furthermore, an eligible and electing taxpayer under Section 121 is entitled to exclude no more than $125,000 of gain from the sale of a principal residence. If Section 121 is used in conjunction with Section 1034, the amount realized is first determined without applying Section 121; then Section 121 is applied to reduce the amount realized by the exclusion amount.70 The operation of these two rules indicates that it is the first $125,000 of gain that is excludable from gross income; the exclusion is not subject to a pro-rata recovery over the entire period installment payments are made. The balance of the amount realized should then be applied first to Section 1034 and then to Section 453. Example 4 of Prop Reg. 1.453(f)(3)(iii) makes it clear that the starting point of the installment sales calculation is the gain realized, and the amounts excluded from gross income under Section 121 cannot be part of the gain realized.
Therefore, for installment sales purposes, the cash amounts received under Section 1034 and Section 121 should be considered the equivalent of nonrecognition property µ called "permitted property" under Proposed Regulation 1.453-1(f)(1) µ which is received along with an installment obligation. Those cash amounts should be eliminated from the first year's payment and should not be part of the numerator or denominator of the installment sales fraction. Since the nonrecognition provisions of Section 1034 will only apply if the cash is eventually turned into permitted property µ another principal residence meeting the requirements of Section 1034 µ receipt of cash in a Section 1034 transaction should be considered permitted property and not part of the installment sales obligation.71
The interplay among Sections 121, 1031, 1034 and 453 is illustrated as follows: Suppose a taxpayer eligible to elect Section 121 owns a residence worth $1,200,000 and has an adjusted basis of $200,000. The home has a rental unit that has been used as a rental unit which equals 25% of the entire residence. The taxpayer desires to sell the residence and acquire a rental condominium for $300,000 and a retirement condominium for $375,000. The terms of the sale are $800,000 down and the balance of $400,000 payable in equal installments of $40,000 per year over 10 years. As part of the down payment, the buyer will acquire the rental condominium for $300,000 and pay $500,000 in cash. The transaction is split into two parts:
With respect to the $500,000 in cash received, $125,000 should be excluded under Section 121 and does not become part of the installment sales calculation despite Revenue Ruling 80-125. The balance of $375,000 will be used to purchase a new residence. The purchase of the new residence is tax-free under Section 1034 and receipt of the cash should not become part of the installment sales calculation despite Revenue Ruling 75. The basis in the new residence will be $150,000.
With respect to the installment sales payments ($40,000 per year for 10 years), the interest received is separately taxable as interest income. Both the gross profit (numerator) and total contract price (denominator) are reduced by the combined amount of Section 1031 and 1034 nonrecognition property received, and the amount excluded under Section 121. Therefore, the fraction that remains is: $400,000/$400,000 = 1. Each installment payment received of $40,000 will be fully taxable when received.
According to the IRS's position in the revenue rulings,72 the gross profit (numerator) would be $400,000 but the total contract price (denominator) would remain at $900,000 which means that 4/9 of each payment, including the $500,000 cash payment in the year of sale, would be taxable when received. Both the Section 121 exclusion and the Section 1034 non-recognition amount would be recovered ratably over the entire 10 year period of the installment sale.
Under the IRS approach a major distortion occurs: If the taxpayer did not use the installment method of accounting, only $400,000 of the $900,000 received would be the gain recognized in the year of sale. The $400,000 subject to gain recognition is the amount remaining after Section 121 and Section 1034 are applied to the first $500,000 received. But according to the IRS, if the installment sales method is used, taxpayer does not receive the first $500,000 tax-free; rather, the taxpayer is treated as recognizing gain on 4/9 of the $500,000 payment. This means the taxpayer is recognizing gain on money that should have been received tax-free.
The IRS's position causes a portion of the cash received on the sale of a principal residence to be taxable in the year of sale merely because the taxpayer chose to use the installment method of accounting. The sale of the old residence and purchase of the new residence is initially a non-taxable event that may become taxable only if the taxpayer fails to comply with Section 1034 µ an event usually determined after the close of the taxable year in which the sale occurs.73 The proper result is to apply the installment sales method of accounting solely to the gain-recognized portion of the transaction and eliminate from the gross profit (numerator) and the total contract price (denominator) the amounts received under Section 1034 and Section 121. This method is consistent with the Section 453(f) approach to the receipt of nonrecognition property under Section 1031.
Section 1034 remains a strong ally of the taxpayer who wants to trade-up residences. Even if the taxpayer has allocated a portion of his residence to business use under Section 280A, Revenue Ruling 82-25 will permit the sale of the residence to be treated under Section 1034 if business use is absent in the year of sale.
Down-sizing a principal residence can be accomplished on a tax-free basis though the use of Section 121 or by converting a portion of the residence into investment property and using Section 1031 to exchange that portion for like-kind property. The balance of the residence can be used to acquire a less expensive residence under Section 1034.
By properly combining Sections 1031, 1034, 121 and the installment sales rules of Section 453, a taxpayer with an enormous potential gain in a principal residence can successfully trade down for a smaller principal residence and investment property, and enjoy the benefits of the installment sale provisions, while paying a minimum of tax. The IRS should be encouraged to apply the installment sales rules to Section 121 and Section 1034 transactions as it does to Section 1031 exchanges, thereby eliminating from the installment sales calculation altogether receipt of cash under Section 121 and Section 1034.
1 Congress was initially concerned with the forced sale of a principal residence due to a change in a taxpayer's job location, a situation comparable to an involuntary conversion under Section 1033. But in the final legislation, Congress broadened the reach of newly enacted Section 1034 to provide that a sale or exchange of a principal residence for whatever reason would be covered. H. Rep. No 586, 82nd Cong, 1st Sess, reprinted in 1951-2 CB 357,377. Congress initially considered the sale of a house for job-related purposes to be similar to an involuntary conversion under Section 1033, but decided to broaden the reach of the newly enacted Section 1034 to provide that any transfer of a residence would be covered.
2 Sec 1034(b). The adjusted sales price is generally the purchase price less fixing-up expenses incurred within 90 days before the contract of sale of the old residence is signed. Payment must be made for the fixing-up expenses on or before the 30th day after the old residence is sold. In order to avoid a double deduction, fixing up expenses are not counted if they are (1) otherwise deductible in computing taxable income (expenses incurred in repairing damage caused by a casualty); (2) taken into account in computing the amount realized; or (3) included in the adjusted basis of the old residence (such as installing a new air conditioner).
3 Section 1034(a). The period for the purchase of a new residence begins 2 years before the old residence is sold and ends 2 years after the residence is sold. The period is really a 4-year period, extending two years before and after the date the old residence is sold. Also, a new residence acquired by gift or inheritance will not qualify, except to the extent of improvements made to the new residence.
4 Regulation 1.1034 -1(c)(3)(i).
6 Revenue Ruling 74-250, 1974-1 CB 202. A married couple owned a principal residence as tenants by the entirety. They sold the principal residence and each purchased a new principal residence. Section 1034 applied to both purchases. For each taxpayer, taxes will be deferred if the cost of the new residence is equal to or greater than his percentage ownership of the old residence multiplied by the adjusted sales price of the old residence.
7 Revenue Ruling 75-238, 1975-1 CB 257.
8 Revenue Ruling 66-159, 1966-1 CB 162. The grantor trust rules are found in Section 671-769 of the Internal Revenue Code.
9 Revenue Ruling 74-411, 1974-2 CB 270.
10 Revenue Ruling 71-495, 1971-2 CB 311.
11 PLR 8928025.
12 Revenue Ruling 77-298, 1977-2 CB 308.
13 U.S. v Sheahan, 323 F2d 383 (5th Cir 1963); Bayley v Cm, 35 TC 288 (1960).
14 Lokan v Cm, 39 TCM 168 (1968).
15 Henzel v Cm 24 TCM 1344 (1965).
16 Joint Committ on Internal Revenue Taxation, Examination of President Nixon's Tax Returns for 1969 through 1972, H. Rep. No 93-966, 93d Cong., 2d Session 117-118 (1974). The staff of the Joint Committee concluded that President Nixon's occupancy on the weekends and holidays of his "Western White House" at San Clemente, California, with an intent to make it his permanent residence upon his leaving the Presidency did not meet the rules of Section 1034 with respect to use of a new residence.
17 Revenue Ruling 75-438, 1975-2 CB 334.
18 Bolaris v U.S. 776 F 2d. 1428 (9th Cir, 1985).
19 Section 1034(c)(2) states that the cost of a new residence will include costs attributable to the acquisition, construction, reconstruction and improvements made which are chargeable to the capital account (expenses for repairs and maintenance do not count), during the period specified under Section 1034(a). Acquisition of raw land and the construction of a residence during the period described in Section 1034(a) will constitute a new residence.
20 Marcello v Cm. 380 F2d 499 (5th Cir, 1967) aff'g on this issue 23 TCM 1847 (1964), cert denied, 398 U.S. 1044 (1968).
21 Rentz v Cm. Para 77,013 P-H Memo TC (1977). Although both Section 1033 and Section 1034 are nonrecognition provisions, they contain different provisions with respect to the type of replacement property, the time limits to purchase the replacement property and the computation of the unrecognized gain.
22 The adjusted sales price is the gross amount realized, reduced by the expenses for work performed on the old residence within a 90 day-period ending on the date the contract for sale was entered into and paid within 30 days after the date the old residence was sold, provided the expenses are not otherwise deductible and have not already reduced the amount realized. These expenses are commonly referred to as "fixing-up" expenses. Section 1034(b)
23 Section 121 allows taxpayers who have reached the age of 55 to make a once-in-a-lifetime election to exclude up to $125,000 of gain in a principal residence. This provision and its limitations will be discussed later in this article.
24 Under Section 121, sale or exchange includes destruction, theft, seizure, requisition or condemnation of a residence.
25 Regulation 1.121-1(c). If a portion of the residence was used for business, then Section 121 will only apply to the non-business portion of the residence. Regulation 1.121-5(e)(2).
26 Regulation 1.121-5(h).
27 Regulation 1.121-1(d) Example (1).
28 Use of Section 1031 with Section 1034 and Section 121 is discussed at length later in the article.
29 Sec 121 (a)(2). Note: This rule applies during a prior marriage in which an election was made and irrespective of whose house was sold during the prior marriage. If a man and woman each own a principal residence prior to marriage and if both are eligible to make the election, the election should be made and a residence should be sold prior to marriage in order to preserve the election for the other property.
30 Regulation 1.121-2(b)(2).
31 PLR 8029088. This ruling is questionable unless the taxpayer retained a true life interest which could be transferred. If all the taxpayer retained was a contractual right to remain in the premises after selling his entire fee simple interest in the property, Section 121 should apply to the sale.
32 The lease term should be less than 30 years in order to avoid the creation of like-kind property under Section 1031. A leasehold interest of 30 years or more is considered like-kind property under Regulation 1.1031(a)-1(c)(2) and if a leasehold interest of 30 years or more is created, the transaction could be characterized as a Section 1031 exchange rather than a sale of a residence.
33 Revenue Ruling 85-45, 1985 CB 183.
34 Note: Generally, however, the residence will receive a basis step-up that will eliminate the gain to date. This limitation will have its greatest effect on residences that appreciate after the death of the first spouse.
35 Section 1031 applies to exchanges of like kind property held in a trade or business or used for the production of income. There are exceptions to nonrecognition treatment listed in Section 1031(b). Note: The definition of an asset which is ineligible under Section 1031 is much broader than the familiar concept of a "capital asset" under Section 1221(2). In other words, a capital asset under Section 1221(2) may not be as asset entitled to nonrecognition treatment under Section 1031.
36 1957-1 CB 247.
37 Section 1031 applies to property held for investment or property used in a trade or business. For purposes of this article, when discussing Section 1031, the term "investment" will include property used in a trade or business.
38 Bolaris v. U.S., 776 F2d. 1428 (9th Cir. 1985); Revenue Ruling 78-146, 1978-1 CB 260.
39 Stolk v CM 40 TC 345, aff'd per curium 326 F2d 760. The taxpayer and his family moved into an apartment in the city during the week and used their county residence on the weekend. On a later sale of the country residence and purchase of another country residence, the court held Section 1034 inapplicable since the city apartment had become the taxpayer's principal residence.
40 In the Revenue Reconciliation Act of 1989, the House tried to place a holding requirement of one year on property received in a Section 1031 exchange. But this proposed change was rejected by the Conference Committee. Therefore, there is not a quantifiable holding period under Section 1031.
41 74 TC 633 (1980).
42 Treas Reg. 1.1034-1(c)(3)(iii) "Where part of a property is used by the taxpayer as his principal residence and part is used for other purposes, an allocation must be made to determine the application of this section." Wigfall v Cm, 82,171 P-H Memo TC (1982) where the court noted that an allocation must be made and accepted taxpayer's allocation over IRS objection.
43 See Reid v U.S., 69-2 USTC Para 9550, 24 AFTR 2d 69-5069 (ED Cal, 1969) where a jury determined that one-third of a ranch was used for business purposes despite taxpayer's claim to the contrary.
44 Cite Revenue Ruling.
45 Section 1031 (a)(3) permits a delayed exchange only if the property is identified no later than 45 days after the old residence is transferred and the acquisition of the new residence must be completed within 180 days. For problems relating to the requirements of contractual interdependence and lack of constructive receipt of the cash in a Section 1031 transaction, see Sommers "Deferred Exchanges Under Section 1031 (a)(3) after Starker" Journal of Taxation, February, 1988.
46 Staff of the Joint Committee on Internal Revenue Taxation, Examination of President Nixon's Tax Returns for 1968 through 1972, S Pre No 768, pt 3, 111-19, 93d Cong, 2d Sess (Apr 3, 1974). Where President Nixon claimed 25% of his cooperative apartment costs as a business expenses, at least 25% would have been treated as non-Section 1034 property.
47 PLR 7935003.
48 1982-1 CB 114.
49 The application of Section 280A has been the subject of numerous articles. If, for instance, a room which has been exclusively used as an office has a television or piano placed in it for personal use in the year of sale, Section 280A will not apply (since the room will no longer be used exclusively for business) and the prior business use will be ignored.
50 As noted previously, there are several options available to the taxpayer who is down-sizing a principal residence. He could exchange the old residence:
The main factor is to ensure that the Section 1034 portion is rolled over into equivalent Section 1034 property and the Section 1031 property is exchanged for equivalent Section 1031 property. Of course, under either Section 1031 or Section 1034, the property received can be of greater value than the portion of the old residence given up without adverse tax consequences.
51 A taxpayer who desires to sell his business and retire if a few years could structure part of the sale price for the business as a consulting agreement and use an office in the home for the consulting business. Care should be taken that the requirements of Section 280A are met. Note: Use of a consulting contract, rather than a total allocation to a covenant not to compete will give the buyer the same current deductions, but will allow the seller as a consultant to fund a retirement plan with the consulting income, an option that is unavailable when income is received solely under a covenant not to compete.
52 54 TC 1298 (1970).
53 The concurring opinion in Newcombe (signed by 7 judges) stated the taxpayer should have rented the property or offered it for rent after abandoning it and before he offered it for sale, or he must have held the property for appreciation after abandoning it.
54 776 F 2d 1428 (9th Cir, 1985).
55 Subdivision or rezoning without engaging in substantial improvements and selling the entire parcel as one piece should not transform the seller into a dealer for purposes of Section 1221(2). See Buono v. Cm., 74 TC 187 (1980). Note, however, that the purpose here is not the sale of the property but its exchange under Section 1031 and the definition of property excluded under Section 1031 (a)(2) includes property "held primarily for sale" as opposed to the exclusion under Section 1221(2) for "property for sale to customers in the ordinary course of a trade or business." In order to exchange the property, the taxpayer will have to hold the property for investment and not primarily for sale. The sale of an entire parcel to one purchaser should suffice under Section 1031.
56 Revenue Ruling 76-541, 1976-2 CB 246. Taxpayer sold his home and 3 acres, then built a home on the remaining 7 acres, then sold 2 of the remaining acres and the Service held all sales were within Section 1034. Bogley v Cm., 263 F 2d 746 (4th Cir, 1959), holding the sale of a principal residence and a later sale of its surrounding acreage constituted a sale within Section 1034. Accord: PLR 8817015, holding the sale of a vacant lot next to taxpayer's residence constituted a sale under Section 1034 provided the house was sold within 2 years thereafter.
57 Section 453(b)(1).
58 This assumes a federal tax rate of 28% and a state income tax rate of 4%. In reality, the effective federal tax rate will probably be 33% for most if not all of the proceeds and the state tax rate will be closer to 6%. The higher the combined tax rate, the more advantageous use of the installment sales method will be.
59 Typically the interest rate on the installment obligation will be at the higher (lender's rate) rather than at the investor's rate, although state law could limit the amount of interest received on a seller-financed debt obligation.
60 The highest maximum federal income tax rate is 28%, but the elimination of the 15% bracket and dependency exemptions at the rate of 5% for certain incomes creates a marginal tax bracket of 33%.
61 Use of the installment sales can be used to postpone the recognition of capital gains on the expectation that Congress reinstitutes some form of capital gains deduction. President Bush has made capital gains reduction a priority, however, whether there will be any change in the capital gains provisions remains to be seen. One way to structure an installment sale is to have a significant payment of principal made in April of the year following the sale. If capital gains are placed back into the Internal Revenue Code, then the taxpayer can elect out of installment sales treatment and use the principal payment to pay the taxes at the lower capital gains amount. Also, the installment note could be sold to the debtor or to a third party to obtain the balance of the cash.
62 For instance, in California Civil Code, Section 2954.9, gives the buyer the right to prepay the principal at the rate of 20% per year with no prepayment penalty after 5 years. Also, in California, under the Code of Civil Procedure, Section 580b, the seller is not entitled to a deficiency judgment on a seller-financed real estate obligation.
63 IRD is not necessarily something to be avoided under all circumstances. Although the person receiving the note will be taxed on the principal at ordinary income tax rates without the benefit of a basis step-up, there will not be an estate tax associated with the installment obligation as well. Therefore, the comparison is between the rate of tax the estate will pay if the asset is part of the estate versus the individual's rate of tax if the asset is sold and an installment note is received.
64 The installment sales provisions are constantly being modified by Congress in response to IRS complaints that some taxpayers are unfairly manipulating the rules. It is now one of the longest code sections in the Internal Revenue Code and contains myriad exceptions and definitions.
65 1953 CB 83.
66 1965-1 CB 356.
67 1980-2 CB 79.
68 Proposed regulations are not law, but they are a strong indication of the Treasury's position on an issue. Example 4 is consistent with the intent and purpose of Section 453(f) to remove the nonrecognition property from the installment sales equation altogether.
69 The treatment of the sale of a principal residence under the proposed regulations is discussed later in this article.
70 IRC Section 121(d)(7). Section 121 (a) expressly states that the exclusion is from gross income (defined in Section 61); therefore, this amount should be treated with greater deference than amounts received in nonrecognition transactions since those transactions result in tax deferral, not tax exclusion from gross income.
71 But apparently the Proposed Regulation does not treat the receipt of cash under Section 1034 in the same manner as the receipt of Section 1031 property for purposes of applying the installment sales rules. Indeed, the proposed regulation seems to ignore the legislative reversal of Revenue Ruling 65-155 which reversed by implication Revenue Ruling 75 (the ruling which first discussed installment sales of principal residences).
72 The IRS's position under proposed regulations 1.453-1(f)(3) (iii) example (4) not would treat the sale of the principal residence as permitted property similar to the receipt of Section 1031 property despite the statement in proposed regulation 1.453-1(f)(3) that such treatment would be afforded to such nonrecognition transactions as the sale of a principal residence. And there is no indication the IRS would exclude the Section 121 payment from the installment sales calculation. Furthermore, Form 6252 used to calculate installment sales income includes both the Section 1034 and Section 121 amounts in the total contract price and as part of the installment sale payments, thus causing the recovery of the Section 1034 and Section 121 payments to be recovered over the life of the installment sale obligation.
73 The IRS could argue that adopting this approach will lead to an open transaction which is an event the regulations under Section 453 try to avoid at all costs. But Section 1034 by its nature involves an open transaction for 24 months after the sale of the old residence and is the proper code section to resolve the open transaction issue. Perhaps the uncertainty of how to treat the payments made on an installment basis during this 24-month period caused the IRS to treat the receipt of cash as part of the installment sale obligation and not as permitted property under Proposed Regulation 1.453-1(f)(3).
|| [Tax Class] | [Hot Topics] | [Estate Planning] | [Employee Stock Options] | [Tax & Trust Scams] | [Foreign Taxes] | [Tax Columns] | [Tax Publications] | [Tax Hound] | [Interactice Apps] | [Cyber Surfing] ||
|All contents copyright © 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.|