Tax Court Questions Whether Sale of Residence Was Due to Wife's Health Problems

(Parker Tax Publishing April 2022)

The Tax Court held that a husband and wife who claimed an exclusion of the gain from the sale of a house under Code Sec. 121 did not qualify for the exclusion under the general rule of Code Sec. 121(a) because they did not use the house as their principal residence for at least two of the five years preceding the sale. However, the court held that there was a genuine dispute of fact whether, under Code Sec. 121(c)(2)(B), the principal reason for the sale was the wife's health problems and the parties had not addressed whether, as a matter of law, this fact was material to the amount of the exclusion. Webert v. Comm'r, T.C. Memo. 2022-32.

Background

Steven and Catherine Webert are a married couple. In 2005, Catherine was diagnosed with cancer, for which she had extensive surgery. That year, she purchased a house on Mercer Island, Washington, where the Weberts resided from 2005 through 2009.

Catherine's health problems immediately became a financial challenge, and she took out a line of credit on the property, which the Weberts used to pay for medical insurance premiums and other medical expenses. After 2005, Catherine continued to suffer numerous accumulating and cascading health problems, which required multiple treatments and for which the Weberts accrued extensive medical bills. Catherine's health conditions reduced her working capacity permanently, contributing to an extended period of financial hardship.

Beginning in 2009, Catherine attempted to sell the Mercer Island house, but was unsuccessful due to the housing market crash. The Weberts did not reside at the Mercer Island house after 2009. Rather, Steven owned a second house in Sammamish, Washington, where the Weberts resided. They began renting the Mercer Island house to third parties in 2009, and it remained rented for the entire year in 2010, 2011, 2012, and 2013, from January through July in 2014, and from March through June in 2015. The Weberts did not use the Mercer Island house personally for any substantial period in 2010 or at all from 2011 through 2015 - even during the periods in which it was not rented. Catherine sold the Mercer Island house on October 20, 2015, for $1,140,000 and realized $194,752 of long-term capital gain pursuant to the sale. In sum, Catherine owned the property for roughly 11 years (2005-15), of which she used it as her principal residence for five years (2005-09) and used it as rental property for six years (2010-15).

The Weberts filed joint federal income tax returns for the years 2010-2015 on which they reported income from their lease of the Mercer Island house. On their Schedule E, Supplemental Income and Loss, they reported 365 fair rental days and zero personal use days of the Mercer Island house for 2011, 2012, and 2013, 212 fair rental days and zero personal use days for 2014, and 122 fair rental use days and zero personal use days for 2015. On their 2015 tax return, the Weberts reported the sale of the Mercer Island house but they excluded the realized gain on the sale from their gross income as gain from the sale of a principal residence under Code Sec. 121. The IRS determined that they were ineligible to claim the exclusion and issued a notice of deficiency. The Weberts took their case to the Tax Court.

Code Sec. 121(a) excludes gain on the sale of property if the taxpayer has both "owned and used" such property as her principal residence for at least two of the five years immediately preceding the sale. Under Code Sec. 121(b)(1), the maximum exclusion of gain from a residence is $250,000 for an individual, or $500,000 for joint returns if (1) either spouse meets the ownership requirements of Code Sec. 121(a) with respect to the property; (2) both spouses meet the use requirements of Code Sec. 121(a) with respect to the property; and (3) the taxpayers meet a third condition not in dispute in this case.

For a taxpayer who qualifies under Code Sec. 121(a) (because he or she satisfies the ownership and use requirements) but has some "periods of nonqualified use" of the property, Code Sec. 121(b)(5) provides for computing the exclusion by allocating gain to "periods of nonqualified use" (which gain is then not excluded). Under Code Sec. 121(b)(5)(C)(ii)(III), those "periods of nonqualified use" do not include a "period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or . . . other unforeseen circumstances." But this computation of nonqualified use is called for only in the instance of a taxpayer who otherwise meets the use requirement.

A taxpayer who fails to satisfy the ownership or use requirement under Code Sec. 121(a) and (b) may nonetheless qualify for a reduced exclusion amount if, under Code Sec. 121(c)(2)(B), the "sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances." Reg. Sec. 1.121-3 provides safe harbors in which a sale or exchange is deemed to be by reason of a change in place of employment, health, or unforeseen circumstances. Under those provisions, a sale or exchange is deemed to be by reason of health if a physician recommends a change of residence for reasons of health. If a safe harbor does not apply, Reg. Sec. 1.121-3(b) provides that "a sale or exchange is by reason of a change in place of employment, health, or unforeseen circumstances only if the primary reason for the sale or exchange is a change in place of employment . . . , health . . . , or unforeseen circumstances."

In a motion for summary judgment, the IRS argued that the Weberts failed to use the Mercer Island house as their principal residence for the requisite period under Code Sec. 121(a). The IRS's motion did not mention health problems and did not discuss or even cite Code Sec. 121(b)(5)(C)(ii)(III) or Code Sec. 121(c)(2)(B). The Weberts responded that they did use the Mercer Island house as a residence and that the reasons for the sale included Catherine's health problems. The IRS argued (in its reply) that the Weberts could not exclude the capital gain realized because - in addition to their failure to use the Mercer Island house - the primary reason for the sale was not a change in place of employment, health, or unforeseen circumstances as required by Code Sec. 121(c)(2)(B).

Analysis

The Tax Court granted partial summary judgment for the IRS on the issue of the use of the Mercer Island house under Code Sec. 121(a) because it found there was no genuine dispute that the Weberts did not use the home as their principal residence for at least two of the five years preceding the 2015 sale. The court noted that the Weberts' returns for years 2010-2015, signed by the Weberts under penalty of perjury, demonstrated lack of personal use of the Mercer Island home because they showed that the Weberts rented out the house to third parties for all but 11 months for those years.

However, the court denied the IRS's motion in part because there was a genuine dispute of fact on the issue of whether, under Code Sec. 121(c)(2)(B), the primary reason for the sale was Catherine's health issues. It seemed clear, the court said, that Catherine's health was both a cause of the need to move from the Mercer Island house and a precipitating cause for the financial circumstances that contributed to that need. Drawing all reasonable inferences in the Weberts' favor, the court found that Catherine's health problems may have been the primary reason for the attempts to sell which began in 2009 and did not succeed until 2015.

It was not clear to the court, however, that the facts about Catherine's health and its effect on the sale were actually material to this case. The court explained that, although Code Sec. 121(c)(2)(B) states that the use requirement under Code Sec. 121(a) does not apply where the sale is by reason of health, the provision does not merely drop the use requirement altogether. Rather, it sets up an alternative limitation, which also turns on use, by creating a fraction that is multiplied to potentially reduce the exclusion amount that would otherwise be claimed. Under Code Sec. 121(c)(1)(B)(i)(I), the denominator of the fraction is two years and the numerator is "the aggregate periods, during the 5-year period ending on the date of such sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence." The court observed that, if the residential use during the five-year period ending on the date of the sale was zero, as the Weberts' was, then it appeared that the fraction would be zero, and the Weberts would get a zero exclusion. Because the parties had not addressed in their briefings whether, as a matter of law, the disputed fact of the primary reason of the sale of the Mercer Island house was a material fact, the court denied in part the IRS's motion for summary judgment.

For a discussion of the exclusion of gain on the sale of a principal residence, see Parker Tax ¶77,701.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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