Reacquisition of personal residence

[natiro]

Client sold her personal residence in 2010 on installement sale. Gain was excluded. 6 months later she foreclosed on the house and now owns it again. What happens when she sells the house again? Let's assume she sells the house again within 3 years of the original sale (so that it would still qualify for exclusion under IRC 121), and that the total gain, incluidng the installment sale gain, is less than $250,000.

Thanks!

[Koss]

No second exclusion

According to IRS Publication 523, Selling Your Home,

You can exclude up to $250,000 of the gain on the sale of your main home if all of the following are true.

You meet the ownership test.

You meet the use test.

During the 2-year period ending on the date of the sale, you did not exclude gain from the sale of another home.

If she sells the house within two years of the date of the first sale, she will not be able to exclude the gain that arises out of the second sale.

But how much will that gain be?

This is going to get really complicated really fast.

What is her basis in the home upon reacquisition by foreclosure?

BMK

[Koss]

Some answers

I'm still thinking this one through, and I haven't reached a real conclusion.

Determination of the basis of property that is acquired through foreclosure comes within the rules for determining the basis of property that is repossessed. There is one set of rules for personal property, and a different set of rules for real property. There are also different rules that apply when the party acquiring the property was not the seller.

In your case, the party acquiring the property through foreclosure was indeed the seller, and it is real property (not personal property).

According to IRS Publication 537, Installment Sales, the basis of real property that is acquired through repossession is calculated using the following worksheet:

Worksheet E. Basis of Repossessed Real Property

1. Enter the unpaid balance on the installment obligation
2. Enter your gross profit percentage for the installment sale
3. Multiply line 1 by line 2. This is your unrealized profit
4. Subtract line 3 from line 1. This is your adjusted basis in the installment obligation on the date of the repossession
5. Enter your taxable gain on the repossession
6. Enter your costs of repossessing the property
7. Add lines 4, 5, and 6. This is your basis in the repossessed real property

But to complete this worksheet, you first need to calculate the taxable gain on the repossession. Pub. 537 has a worksheet for that, too:

Worksheet D. Taxable Gain on Repossession of Real Property

Note.Use this worksheet to determine taxable gain on the repossession of real property if you used the installment method to report the gain on the original sale.

1. Enter the total of all payments received or treated as received before repossession
2. Enter the total gain already reported as income
3. Subtract line 2 from line 1. This is your gain on the repossession
4. Enter your gross profit on the original sale
5. Enter your costs of repossessing the property
6. Add line 2 and line 5
7. Subtract line 6 from line 4
8. Enter the lesser of line 3 or
line 7. This is your taxable gain on the repossession

There's also an app for this available on your iPhone.

Just kidding.

What is not clear to me is whether the exclusion of the gain on the original sale has any impact on how basis is determined. I don't think it does. I think these rules are applicable regardless of whether the house was the seller's personal residence, and regardless of whether the gain was excluded.

It is possible, however, that the repossession somehow nullifies the original sale. If this is the case, then your client might be able to exclude the gain on the second sale, after all.

According to Pub. 537,

The rules for the repossession of real property allow you to keep essentially the same adjusted basis in the repossessed property you had before the original sale. You can recover this entire adjusted basis when you resell the property. This, in effect, cancels out the tax treatment that applied to you on the original sale and puts you in the same tax position you were in before that sale.

As a result, the total payments you have received from the buyer on the original sale must be considered income to you. You report, as gain on the repossession, any part of the payments you have not yet included in income. These payments are amounts you previously treated as a return of your adjusted basis and excluded from income. However, the total gain you report is limited. See Limit on taxable gain, later. [Emphasis supplied]

This explanation suggests that the application of these rules has the effect of unwinding the sale. I am particularly intrigued by the part that says that the repossession "cancels out the tax treatment that applied to you on the original sale, and puts in the same tax position you were in before that sale." So it is almost as if the original sale never happened.

The problem with this analysis, in your client's case, is this:

How can the seller be put "in the same tax position" they were in before the sale if they no longer occupy the home? The repossession may "undo" the sale, and perhaps the intent of these rules is in fact to make it as if the sale had never happened. But you can't "undo" the fact that the house is no longer the taxpayer's principal residence.

Bummer.

Unless they move back in...

One final thought:

Are you absolutely certain that this was a true foreclosure?

Did the seller go through the foreclosure process in court? Or did they reach some sort of agreement with the buyer to "take the house back?"

This is sometimes referred to as a "deed in lieu of foreclosure." And that's still a repossession. But you may want to look into the details further. If it wasn't a full-blown foreclosure, then these rules for determining basis may not be applicable, and your client may have some other options...

BMK

[Koss]

Amend the return?

Natiro, you may have to start thinking outside the box here...

Maybe your client should amend the return for the year of the original sale, to elect not to exclude the gain on that sale, so that the exclusion is still available when she sells the house again?

How bad would that gain be, on the installment sale method, at capital gain tax rates?

Like I said, this is going to get really complicated, really fast...

BMK

[taxxcpa]

pub 537

For determination of basis of a repossessed house sold on an installment basis, use the example shown in Pub 537.

[natiro]

Reaquisition of personal residence

Thanks for all the answers. I checked in Publ 537 and it said there are special rules for reaquision of personal residences and says "see Reg 1.1038-2", which I did. Actually the reason I originally posted was because I had read IRC 1038 and was confused by the language, but the Reg seems to spell it out in more detail. Basically, if the re-sale of the residence occurs within one year of the reacquisition, the original sale and the re-sale are treated as one transaction. Of course, the Reg is much more wordy than that, but that's it in a nutshell! Again, thanks for all the thoughtful answers which pointed me in the right direction.