Flipper using Primary Residence exclusion to pay no capital gains tax??

[ATSMAN]

I was introduced to a couple that has been flipping houses in my general area for the last decade through another client. They expressed an interest in using my tax prep services next tax season. I was shocked to find that this couple filing MFJ has been using the primary residence exclusion all along. What they do is move into the house they just fixed up and live there for two years as their primary residence (they do have another house) and then they sell it claiming the exclusion. They make sure the closing attorney does not issue a 1099-S and they never file a Sch-D. They just sold a house last month and are planning to do the same at tax filing.

I don't think it will pass muster upon audit. What are your thoughts.

[kathyc2]

If they are truly living in flip house I don't know they are doing anything wrong.

Some things I would be asking/looking at for assurance they are actually living there as opposed to just saying so would be:

Was the other house just sitting empty while they were living in flip?
If state has a homestead exemption, which house was it filed on?
Which address was used for PY tax return and drivers licenses?
Ask for optional utility bills such as internet and cable from both houses. If one doesn't have these, that is likely the house that was not being lived in.

[TAXNJ]

Think one can use the exclusion any number of times over their lifetime as long as they satisfy the requirements for the exclusion,

Better to use a source to reference.

From IRS website:
Qualifying for the Exclusion

In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test. You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you're not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.

[Burke]

I once had friends (not clients) who did this. He was in the construction business, and would build a house, live in it for 2 years, then sell it. It truly was their personal residence during that time frame, and it was perfectly legal. They had no children, so were free to live this lifestyle. Moving every 2 years means they did not accumulate years of stuff to dispose of. Not for everyone, but there is nothing wrong with it. It is a provision that benefits many people, and as long as it is part of the tax code, some will take advantage of it in this manner. I also had a client who sold his former personal residence, but he did so 8 years after moving out. He did not realize that it would be taxable capital gain and signed documents at closing which caused the attorney not to issue a 1099-S. I guess he didn't read the fine print.

[ATSMAN]

If they are truly living in flip house I don't know they are doing anything wrong.

Some things I would be asking/looking at for assurance they are actually living there as opposed to just saying so would be:

Was the other house just sitting empty while they were living in flip?
If state has a homestead exemption, which house was it filed on?
Which address was used for PY tax return and drivers licenses?
Ask for optional utility bills such as internet and cable from both houses. If one doesn't have these, that is likely the house that was not being lived in.

It is my understanding that they actually live in the house they rebuilt. Their other house is used as a second residence. Wife's mom lives in that house temporarily. I believe they vote in the ward where they actually live. Tax return shows same address. Not sure about driver license. The fact that they avoid getting a 1099-S is questionable??

What would be my exposure if IRS audits them and determine that they are not eligible for the personal residence exclusion because it is a sham arrangement?

[kathyc2]

If they sign the form at closing that this was their primary residence, title company has no obligation to issue 1099S, so I don't see that as questionable.

If IRS questions it, I would assume they would be looking at if it actually was the primary residence. To me if does look a bit fishy since they also maintained the same additional home during the decade. If you want to protect yourself from an accuracy penalty, keep documentation as to what you used to determine they were living there. You may also want to maintain records as to what you looked at to determine they should not have rental income.

If you are uncomfortable with their arrangements, just pass on taking them on as client.

[ATSMAN]

After thinking about this a lot and reading your comments, I have decided to not take this engagement. I have not told these people yet. I am waiting for them to make the first move. I have a feeling that they were looking around for another tax preparer because their current preparer may want to wash their hands off this hot potato. I just know that they may be close to stepping over the line and get me in trouble as well. I would also suspect that they may be playing fast and loose with their expenses. It is not worth the aggravation! My client who introduced me to them, had actually purchased a home from them for his daughter (also my client), so I have to be also mindful about those relationships as well.

[Burke]

You say the mother is living in the residence claimed as a second home. I really don't see where this is a questionable issue if the facts are what you describe. As Kathyc2 says, if they sign the document that it is their personal residence for the required time frame, the lack of a 1099-S is not an issue. That's their problem if it is not accurate, and I don't see where any evidence has been presented here that contradicts that. Some states allow that the settlement statement qualifies as a 1099-S, and I have had cases where clients never got one and should have. If I determined that it was a reportable transaction, I did so whether or not they had the 1099. I always asked for the settlement statements on the buy & sell ends for each property sold. I do not see where you have any liability as a preparer for lack of a 1099-S as long as you have all the documentation per your due diligence (including the signed document certifying Sec 121 eligibility.) "Playing fast and loose with their expenses?" Is this just a feeling or do you have some knowledge of this?

[TAXNJ]

You say the mother is living in the residence claimed as a second home. I really don't see where this is a questionable issue if the facts are what you describe. As Kathyc2 says, if they sign the document that it is their personal residence for the required time frame, the lack of a 1099-S is not an issue. That's their problem if it is not accurate, and I don't see where any evidence has been presented here that contradicts that. Some states allow that the settlement statement qualifies as a 1099-S, and I have had cases where clients never got one and should have. If I determined that it was a reportable transaction, I did so whether or not they had the 1099. I always asked for the settlement statements on the buy & sell ends for each property sold. I do not see where you have any liability as a preparer for lack of a 1099-S as long as you have all the documentation per your due diligence (including the signed document certifying Sec 121 eligibility.) "Playing fast and loose with their expenses?" Is this just a feeling or do you have some knowledge of this?

Agree. Well stated.

If the Original Poster is uncomfortable then pass on doing the return.

[ATSMAN]

"Playing fast and loose with their expenses?" Is this just a feeling or do you have some knowledge of this?

It was my impression based on some conversations I have had with this potential clients. Again I have not reviewed any of their prior returns. Before I sign the engagement letter I review at lest three prior returns of business clients. As I posted before, I am going to pass on this engagement. I can smell trouble in future years!

[Burke]

Sometimes there is a gut feeling; I tend to trust mine.