Paul L. Caron

Monday, April 25, 2022

Lesson From The Tax Court: The Unforeseen Circumstances Rule For §121 Home Sale Exclusions

Camp (2021)The Tax Code gives homeowners many tax breaks.  Chief among them is the ability to exclude up to $500k of gain from the sale of a principal residence (for married taxpayers filing jointly).  Taxpayers seeking this exclusion must meet some basic requirements, set out in §121.  Taxpayers who fail the requirements, however, may still qualify for an exclusion under the unforeseen circumstances rule in §121(c).

Steven W. Webert and Catherine S. Webert v. Commissioner, T.C. Memo. 2022-32 (Apr. 7, 2022) (Judge Gustafson), teaches a lesson on the operation of the unforeseen circumstances rule.  There, unforeseen circumstances arguably forced the taxpayers to move out of their home during a real estate bust in 2009.  Apparently unwilling to sell short, they rented out the home until the market recovered and eventually sold it for a gain of about $195k in 2015.  They attempted to exclude the gain under §121, claiming they were entitled to do so because of the unforeseen circumstances rule in §121(c).  The IRS thought the claim had no merit.  Curiously, the Tax Court did not (yet) agree.  Beats me on why.  I explore the rule, and the mystery of why the IRS lost its Summary Judgment motion, below the fold.

Law: The Home Sale Exclusion History
Here’s a brief history of the home sale exclusion.  For those who want more, this Congressional Research Service Report (CRS RL32978) does a great job.  For those who don’t care, just skip on down.

The first tax benefit home sale gains came in 1951 when Congress began allowing taxpayers to avoid tax on gain from the sale of a principal residence if they bought a new principal residence of equal or greater value within a year from the same.  The idea was that most home sales were in response to family or employment changes and so the were more “of the nature of an involuntary conversion” rather than a sale for profit.  See the Sen. Rep. 82-781, as quoted in the CRS Report, supra.  Allowing deferral would facilitate the strong post-WWII movement of labor.

The second tax benefit came in 1964 when Congress created §121 as a one-time exclusion for taxpayers who had used the home as their principal residence in 5 of the prior 8 years before the sale (“the use requirement”). §206 of the Revenue Act of 1964, P.L. 88-272, 78 Stat. 19.  The exclusion was limited to $20,000, eventually rising to $125,000 by 1981 and by then Congress had shortened the use requirement to 3 of the prior 8 years.  The idea behind this benefit was similar to one of the traditional rationales for capital gains tax rates: that the nominal gain from home sales reflected simple inflation as much or more than real appreciation of value.

Law: Current Basic Rules
Congress did a major overhaul of the exclusion in 1997 to create the exclusion as we pretty much know it now: single taxpayers may exclude home sale gain from income up to a cap of $250k and married taxpayers may exclude up to a cap of $500k. Gone is the requirement to buy a new residence.  Gone is the use-once-in-a-lifetime restriction.  Instead, current §121 combines the features of the old rollover and the old one-time exclusion through operation of three basic rules: (1) an ownership requirement; (2) a use requirement; and (3) an anti-flipping limitation.  Let’s take a quick look at each.

(1) Ownership requirement.  This is the most straightforward.  Look back five years from the date sold.  The taxpayer must have owned the property for at least two of those five years. §121(a).  Married taxpayers can get the basic $250,000 exclusion even if only one spouse meets both tests.  They get the $500,000 exclusion if either spouse meets that 2-in-5 ownership requirement, so as long as both meet the use requirement. §121(b)(2)(A), (B).

(2) Use requirement.  This is more complex.  Generally, a taxpayer must have used the property as their principal residence for a period aggregating two years or more of the five-year look-back period. What makes this complex is when the taxpayer has more than one residence, or has regular temporary absences, or becomes physically or mentally incapable of self-care and has to go to a hospital, nursing home, or similar facility.  Sometimes those absences do not count against the use requirement and sometimes they do. See e.g. Guinan v. U.S., No. CV 02-0261-PHX-PGR (D. Ariz. Apr. 9, 2003) (TPs who had owned and used three homes could not establish that the one they sold was their principal residence). As Treas. Reg. 1.121-2(b)(2) puts it: “whether property is used by the taxpayer as the taxpayer's principal residence depends upon all the facts and circumstances.”  Oh joy.

(3) Anti-flipping limitation. Taxpayers may use the section 121 exclusion as many times as they want subject only to an anti-flipping restriction in section 121(b)(3) that limits the exclusion to only one sale every two years.  So yes, you can buy a house, move in, fix it up and sell it, but only once every two years.

Law: The Unforeseen Circumstances Rule
Sometimes, life throws a curveball. Congress recognized that taxpayers sometimes have to sell their principal residence before their use and ownership during the five year period before the sale fully qualifies them for the §121 exclusion.  Yes, that bolded language is important for today's lesson.  When the sale is because of “a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.”  §121(c)(2)(B), there is a special rule that kicks in.  It's called the unforeseen circumstances rule.  It says that the anti-flipping limitation will not apply, and that the applicable cap on exclusion will be reduced by a ratio, where the numerator is basically the period of qualifying use and ownership, and the denominator is two years.

The basic example I use in class is where unforeseen circumstances force the taxpayer to sell their home after one year of use and ownership during the five year period before the sale. That creates a ratio of 1/2, or one-half, or 50% if you like.  If the taxpayer is single, that means the applicable cap of $250,000 gets reduced to a cap of $125,000. That means the taxpayer can exclude up to $125,000 of gain.

By almost any measure, the statute is very generous. According to this Report of median home sales by National Association of Realtors, that example of being able to exclude $125,000 after a single year of ownership would completely cover almost every taxpayer except perhaps those in very high-priced markets such as San Francisco where the median home prices rose from $1.1 million and 2020 to $1.3 million in 2021.  Even there, however, it is unlikely a taxpayer be able to generate a gain if the taxpayer incurred normal transaction costs.

The regulations even more generous than the statute!  They broadly define unforeseen circumstances as those events “that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.”  Treas. Reg. 1.121-3(e)(1).  The regulation gives one example as being multiple births from the same pregnancy, where H and W buy a two-bedroom condo that they use as their principal residence and one year later W gives birth to twins.  H and W sell their condo to buy a larger home.  The regulation says H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

And the IRS is even more generous than the regulations!  For example, In PLR 200665204  unmarried taxpayers A and B bought a house together and moved in.  Seven months later taxpayer A discovered she was pregnant.  Who could have guessed that would happen?  They split up and wanted to sell the house.  The IRS said that the pregnancy was an unforeseen circumstance and qualified them to claim a reduced maximum exclusion under the subsection (c) formula.  The PLR is silent on whether there were special facts here on why the pregnancy could not reasonably have been anticipated so we are left to scratch our heads.

But no matter how generously one stretches the term “unforeseen circumstances,” §121(c) only applies to sales where the taxpayer meets some, but not all, of the ownership and use requirements in the five year period before the sale.  Ooooh.  More bold foreshadowing!  That is because the subsection creates a ratio and that ratio then determines how much of the cap you have left.  That is, you multiply the ratio by the applicable cap to determine the modified cap amount.  Pretty basic math.

Go back to the basic example.  If instead of selling the house after one year, the taxpayer instead rents out the home for the next six years and then sells it, the taxpayer will have zero in the numerator.  That is because there is no use of the property as a principal residence in the five year period before the sale. The taxpayer has now used the house as a principal residence for zero years of the five year period before the sale.  That means the ratio is zero.  That means the statutory cap (whether the $250k or $500k cap) is also zero because, as we all should have learned before fifth grade, any number multiplied by zero

Put another way, the assumption underlying the unforeseen circumstances rule is that the taxpayer will have met some portion of the ownership requirement and use requirement in the five year period before the sale.

Today’s case illustrates that assumption underlying the unforeseen circumstances rule. Let’s take a look.

Mr. and Ms. Webert married in 2004.  In 2005 Ms. Webert bought a home on Mercer Island, an upscale enclave just east of Seattle, WA which the couple made their principal residence.  Although not in the opinion, it appears they purchased the home for $794,000, according to this Zillow page (assuming I found the right house).  Mr. Webert continued to own a home in nearby Sammamish, WA.  At some point in 2005—whether before or after buying the home—Ms. Webert was diagnosed with cancer and in the subsequent years she continued to have “numerous accumulating and cascading health problems, which required multiple treatments and [created] extensive medical bills.”  Op. at 3.

By 2009 the Mercer Island house had became too expensive to live in.  The Weberts moved over to the Sammamish WA house and tried to sell the Mercer Island house.  However, as Ms. Webert testified at trial: “The financial and housing markets crashed in 2008 and hit the Seattle area particularly hard, so the house in Mercer Island would not sell....”  Instead, “it finally got rented out in sheer desperation, because [Mr. Webert] was no longer able to pay the payments...”  Op. at 3.

The Weberts rented out the Mercer Island house for about six years—always claiming zero or de minimis personal use days on their Schedule E’s for 2010-2015.  They finally sold it once the market recovered, in 2015, for $1.14 million.  That was pretty close to the median sales price of homes that year.  According to this Mercer Island real estate blog post from January 2016, “Mercer Island continues on a three year trend of double-digit appreciation with the median sale price of single family homes ($1,199,500) increasing by 10.6%.” Judge Gustafson sums it up: “Ms. Webert owned the property for roughly 11 years (2005–15), of which she used it as her principal residence for 5 years (2005–09) and used it as rental property for 6 years (2010–15).” Op. at 4.

Curiously, they reported a gain of only about $195k.  So maybe I’m wrong that they bought the house for $794k.  Or maybe they made extensive renovations to it.  Or maybe they just mis-reported the gain.  I would think six years of depreciation would also really increase the gain to be reported on the sale.  But what do I know?

Even more curiously, on their 2015 return, the Weberts excluded the $195k gain from income.  On audit, they claimed they had properly excluded the gain under §121.  The IRS said no way.  And their return apparently had other problems.  The IRS sent out an NOD proposing to assess more than $231k in deficiencies for 2015.

The Weberts petitioned Tax Court and, again, the IRS said no way on the §121 issue, moving for partial summary judgment on just the question of whether they were entitled to exclude the $195k from income under §121.

Now, here’s where it gets interesting.  The Weberts had divorced the year after they sold the house.  So by the time the matter got to Tax Court, they each put in separate appearances.  Ms. Webert was represented by counsel, who quite rightly was willing to concede the §121 issue.  She had good tax attorneys.  But Mr. Webert, proceeding pro se, was not willing to concede the issue.  He claimed that the unforeseen circumstances rule allowed enabled them to claim the §121 exclusion.

Mr. Webert has a very confused understanding of the unforeseen circumstances rule and I think it confused Judge Gustafson, too.  It sure as heck confused me!  It made me go back and really read §121(c) verrrrrry carefully.  After doing that, I think we do have a really good lesson here.

Lesson: Unforeseen Circumstance Rule Is No Help After TPs Cease To Qualify For §121 Exclusion
Remember, Judge Gustafson is ruling on a motion by the IRS for partial summary judgment.  The basic idea there is that a court can issue a ruling on an issue when the issue is purely a matter of law and all the facts are agreed upon.  If, however, there is a legitimate dispute about some fact that would affect the legal analysis—what we call a “material fact”—then a court will not grant summary judgment until it resolves that factual dispute.  See Tax Court Rule 121.

It appears that Mr. Webert wanted to argue that there was a legitimate dispute about whether Ms. Webert’s illnesses in 2005 and later years constituted an unforeseen circumstance.  Sure.  Maybe there is.  But it is not clear why that makes any difference.  It's not a material fact.

Judge Gustafson seems to think the dispute does make a difference.  He notes that if the “primary reason” for a sale is because of an unforeseen circumstance, then §121(c) will apply.  He then writes:  “it appears that the health problems may have been the primary reason for the attempts to sell which began in 2009 and did not succeed until 2015. Consequently, we find a genuine dispute on that factual issue, and we assume that health reasons were the primary reason for the sale.”  Op. at 11.

I'm lost.  I'm confused.  I fail to see how the dispute makes any difference.  It's so not material.  When the house sold in 2015, Ms. Webert had not used it as her principal residence during the entire 5-year lookback period.  Zero.  Zilch.  Nada.  So even if you assume her health problems were the primary cause of moving out in 2009, thus triggering the §121(c) unforeseen circumstances rule, a proper application of the rule results in a zero exclusion amount.  Remember that basic math?

I see two possible reasons for confusion here.

First, there might be a confusion about the “non-qualified use” rule.  That is, §121(b)(5) provides that any amounts of gain attributable to “periods of non-qualified use” may not be excluded.  The idea here is consistent with the Congressional intent to give this exclusion to taxpayers whose gain is really incidental to the reason for them having bought and used the house being sold.  Thus, when a long-time landlord moves back into a rental for two years and then sells it, the resulting gain is at least partially due to the profit-seeking motive that led to the rental use.  Unexpected and/or short absences, however, do not count as non-qualified use.  So it seems Mr. Webert wanted to argue that happened here.

The non-qualified use rules simply do not apply, however, to the time period after qualified use ceases.  Congress recognized that sometimes taxpayers have trouble selling their home and have to rent it out for a period of time after they move out. That is why §121(b)(5)(C)(i) says that non-qualified use does not include any time after a taxpayer moves out of the house and ceases to use it as a principal residence.  Notice that this gives taxpayers a short 3-year period in which to become landlords, take the rents, ride the appreciation for a bigger gain and still get the §121 exclusion.

Once the Weberts left the Mercer Island home in 2009, they never again used it as their principal residence.  Thus, none of their rental period is “non-qualified” use.  So they don't need any of the special rules about when non-qualified use will be excused.  But, again, since they did not use their (former) home as a principal residence for any of the five years before the sale, it does not matter.  They needed to have sold it within five years.  They did not.

Second, a confusion might arise here in how to apply the unforeseen circumstances rule.  That is, one might read the statute to mean that you apply §121(c) by using the ratio to determine the amount by which to reduce the $250k/$500k cap.  If so, then zero times $250/$500 is zero which means you reduce the applicable cap!  No reduction! 

But a careful reading of §121(c), plus a little commonsense, quickly corrects that confusion.  As to the careful reading, the statute says “the dollar limitation ... shall be equal to....” It does not say “the dollar limitation ... shall be reduced by ....”  So, again, zero times $250/$500 is zero.  If zero is your cap, then you ain’t got no exclusion.

As to the commonsense, well, come on: Mr. Webert's reading of §121(c) as still allowing the maximum exclusion for sales outside the 5-year lookback period just because the primary reason for moving out lo! those many years before was unforeseen at the time of the original purchase leads to absurdities. Given the generous interpretation of “unforeseen circumstance” in the statute, regulation, and IRS application, taxpayers could easily convert their homes to rental properties and exclude all post-occupancy appreciation up to the maximum statutory cap no matter how many years they hold the property for rental.  And it would blow a hole in the non-qualified use rule.  Savvy taxpayers would move into a house, then after two years move out when a suitable “unforeseen circumstance” occurs and then rent, facing no limitation below the statutory cap for exclusion.  Finally, it punishes the the poor schlubs who actually sell their homes after being forced to move by treating them worse (reducing the cap) than those more fortunate taxpayers who elect to rent out forever (escaping any reduction in the cap).  That's weird.

Sure, the Weberts may have been in a hard place in 2009.  I don’t know.  But Ms. Webert's claim that “the house in Mercer Island would not sell....” is difficult to believe.  You can always sell a house.  You may not want to, especially if your only option is a short sale.  I totally understand as I explain in the Coda, below.  So The Weberts did the financially smart thing.  They rented out the house until the market recovered.  One of the consequences is they lost the §121 exclusion.  So what?  That left after-tax money jingling in their bank account instead of them having to take money out to pay someone to buy their house!  It was still the smart move to make.  No need to get all greedy-Gus and try to exclude the gain.

Coda: Among the non-tax lessons I teach in my tax class is this one: never buy a one-bedroom condominium.  While they are usually the most affordable homes, they are also the canaries of the real estate market, being the first to fall in a downturn.  When I bought Unit 105 in River Towers (in the Va. suburbs of D.C.) in 1988 for $72,750, it was the peak of that real estate boom and a 1-BR was all I could afford.  When my wife and I started our life together in 1994 up in Maryland, the real estate market had been busted since, well, just after I bought the condo.  The best offer I could generate for the condo was about $10k below my mortgage balance.  Well, heck, like the Weberts, I did not want to pay someone to take my condo!  Luckily, I was able to rent it for my carrying costs.  When we moved to Lubbock in 2001, the condo sold for $76k, generating about a $18k gain.  I did not mind the capital gains tax.  I was grateful I had a gain on which to pay tax.  According to Redfin, my former unit sold in 2009 for $160,000, apparently just before that particular market crash.  It last sold in 2019 for $168,000.  First to fall.  Last to rise.  Never buy a one-bedroom condo. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week for another Lesson From The Tax Court.

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