How to allocate sales price between two principal residence sales?

[ScottSpringerCPA]

Taxpayer and wife own some land with a rock house and a trailer house. They've been there for decades and are selling. Their plan is this:
1) Sell rock house with half the land and take $500K gain exclusion for principal residence.
2) Move into trailer house for 2 years then sell it and take gain exclusion for principal residence.

This strategy works but a portion of the gain on Sale #2 will not be excludable because there were periods of non-qualified use after 2008.

A single buyer wants all of the property and is willing to wait while taxpayer satisfies the residency requirement. They will sign a binding agreement now to do sale #1 this year and sale #2 within 3 years. Taxpayer and buyer are now trying to determine how the total sale price should be allocated between the two sales. Are they free to do it however they want to minimize taxes? Or does the allocation need to be roughly proportional to the FMV?

[ScottSpringerCPA]

Thanks. My understanding from the taxpayer is there will be three agreements:
1) Agreement to sell both properties, one in 2019 and the other within 3 years.
2) The actual sales agreement for the first property. Closing will happen in 2019 and ownership will transfer.
3) The actual sales agreement for the second property. Closing will not happen until 2022 and ownership will not transfer until then.

I don't see this as an installment sale because ownership wouldn't transfer on the 2nd property in 2019. It won't actually be sold yet.

So the question is if taxpayer is required to allocated the combined sales prices in proportion to FMV or if they can allocate however they want (to minimize taxes).

[Maude Lebowski]

The taxpayer isn't required to do anything, but you should consider both the "business purpose doctrine" and "substance over form" when allocating the total sales price. See Gregory v Helvering: https://en.wikipedia.org/wiki/Gregory_v._Helvering.

In other words, pigs get fat, hogs get slaughtered.

[TaxGuyBill]

Or does the allocation need to be roughly proportional to the FMV?

Yes.

However, more "red flags" are waiving through my mind. Is this REALLY two separate properties? What was the trailer house used for in the past? Has the land be legally subdivided? Without knowing the details, I'm suspicious it MIGHT really be the sale of a "partial interest" in the ONE property, in which case the exclusion would be limited to a TOTAL of $500,000.

[ScottSpringerCPA]

TaxGuyBill , my understanding is that the land has been legally subdivided. The trailer house was purchased for their son. It's in their name (not the son's), and they are the ones who paid for it. The son moved out some time ago. I asked the taxpayer if the trailer house was ever rented out because I know that could trigger depreciation recapture.

[Dusty2004]

Seems to me, if they have an agreement to sell it all, that they have one sale with 2 installments not 2 separate sales.

[Burke]

If the land has been legally subdivided, then it should be easily appraised. 121 exclusion can apply to a trailer. The preponderance of value would likely be on the permanent home & lot and you would have to allocate using a reasonable fair market value. They cannot "allocate however they want to minimize taxes." If legally subdivided, the tax assessments should be separate with the locality and there would be values on each. If it is not subdivided on record with the county/city, then you use pro-rated acreage to determine value of the land. Once part of it is sold, it will be separate. The 2nd contract should be an Option to Buy, dated later than the sale contract. In this case, the buyer may not be obligated. Hence, the term "Option." If he pays an upfront fee for this right, and he reneges, the seller keeps the fee and it is ordinary income at the time it is forfeited. It may be possible to do this without any fee, or money changing hands. An attorney familiar with real estate laws in their state should draw up the contract, and it must be legally enforceable according to its terms. Anything could happen in the meantime.