By: Steven D. Hamilton, Principal, Steven D. Hamilton, CPA

November 19, 2015 7:05 pm EST
tax path

Despite the chatter of politicians, we are not soon filing income taxes on the back of a postcard. A major reason is the calculation of income itself. There can be reasonable dispute in calculating income, even for ordinary taxpayers and far removed from the rarified realms of the ultra-wealthy or the multinationals.    

How? Easy. Say you have a rental duplex. What depreciation period should you use for the property: 15 years? 25? 35? No depreciation at all? Something else?

And sometimes the reason is because the taxpayer knows just enough tax law to be dangerous.

Let’s talk about a fact pattern you do not see every day. Someone sells a principal residence – you know, a house with its $500,000 tax exclusion. There is a twist: they sell the house on a land contract. They collect on the contract for a few years, and then the buyer defaults. The house comes back.  

How would you calculate their income from a real estate deal gone bad?

You can anticipate it has something to do with that $500,000 exclusion.

Marvin DeBough bought a house on 80 acres of land. He bought it back in the 1960s for $25,000. In 2006 he sold it for $1.4 million. He sold it on a land contract.

COMMENT: A land contract means that the seller is playing bank. The buyer has a mortgage, but the mortgage is to the seller. To secure the mortgage, the seller retains the deed to the property, and the buyer does not receive the deed until the mortgage is paid off. This is in contrast to a regular mortgage, where the buyer receives the deed but the deed is subject to the mortgage. The reason that sellers like land contracts is because it is easier to foreclose in the event of nonpayment.

DeBough had a gain of $657,796.

OBSERVATION: I know: $1.4 million minus $25,000 is not $657,796. Almost all of the difference was a step-up in basis when his wife passed away.  

DeBough excluded $500,000 of gain, as it was his principal residence. That resulted in taxable gain of $157,796. He was to receive $1.4 million. As a percentage, 11.27 cents on every dollar he receives ($157,796 divided by $1,400,000) would be taxable gain.

He received $505,000. Multiply that by 11.27% and he reported $56,920 as gain.

In 2009 the buyers defaulted and the property returned to DeBough. It cost him $3,723 in fees to reacquire the property. He then held on to the property.

What is DeBough’s income?

Here is his calculation:

I don’t think so, said the IRS. Here is their calculation:

DeBough was outraged. He wanted to know what the IRS had done with his $500,000 exclusion.

The IRS trotted out Section 1038(e):

(e) Principal residences.


(1) subsection (a) applies to a reacquisition of real property with respect to the sale of which gain was not recognized under section 121 (relating to gain on sale of principal residence); and

(2)  within 1 year after the date of the reacquisition of such property by the seller, such property is resold by him,

then, under regulations prescribed by the Secretary, subsections (b) , (c) , and (d) of this section shall not apply to the reacquisition of such property and, for purposes of applying section 121 , the resale of such property shall be treated as a part of the transaction constituting the original sale of such property.

DeBough was not happy about that “I year after the date of the reacquisition” language. However, he pointed out, it does not technically say that the $500,000 is NOT AVAILABLE if the property is NOT SOLD WITHIN ONE YEAR.

I give him credit. He is a lawyer by temperament, apparently.  DeBough could find actionable language on the back of a baseball card.

It was an uphill climb. Still, others have pulled it off, so maybe he had a chance.

The Court observed that there is no explanation in the legislative history why Congress limited the exclusion to sellers who resell within one year of reacquisition. Still, it seemed clear that Congress did in fact limit the exclusion, so the “why” was going to have to wait for another day.

DeBough lost his case. He owed tax.

And the Court was right. The general rule – when the property returned to DeBough – is that every dollar DeBough received was taxable income, reduced by any gain previously taxed and limited to the overall gain from the sale. DeBough was back to where he was before, except that he received $505,000 in the interim. The IRS wanted its cut of the $505,000.

Yes, Congress put an exception in there should the property be resold within one year. The offset – although unspoken – is that the seller can claim the $500,000 exclusion, but he/she claims it on the first sale, not the second. One cannot keep claiming the $500,000 over and over again on the same property.

Since Debough did not sell within one year, he will claim the $500,000 when he sells the property a second time.

When you look at it that way, he is not out anything. He will have his day, but that day has to wait until he sells the property again.

And there is an example of tax law. Congress put in an exception to a rule, but even the Court cannot tell you what Congress was thinking.

The views and opinions expressed herein are those of the author(s). Core Compass’s Terms Of Use applies.

About the author

Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

principal residencehome tax exclusionland contractIRC Section 1038(e)
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