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Major acreage qualifies as residential for tax break.

Sec. 121 permits an individual to exclude from income up to $250,000 ($500,000 for joint returns) of gain realized on the sale or exchange of a residence. Schlicher, TC Memo 1997-37, and Rev. Rul. 76-541 allowed a personal residence with large contiguous tracts of land to be bifurcated and sold in separate transactions. It appears that these authorities can be used in conjunction with new Sec. 121 to exclude gain from multiple sales of a large property that has been owned and used as a primary residence.

Neither the Code nor the regulations provide a specific method to ascertain the portion of a large plot of land attributable to nonresidential versus residential use. In Schlicher, the taxpayer had his principal residence on five acres in Livermore, California. He owned horses that he kept on the property, and operated a horse boarding and breeding business on leased property adjoining his five acres. In 1988, Schlicher sold his home, realizing a $419,000 gain. A few months later, he purchased 51 acres of undeveloped land in Clayton, California, for $380,000. Within two years of the Livermore home sale, he constructed a residence, garage and barn on the Clayton property that cost approximately $147,000. He fenced off 7 1/2 acres for a horse boarding and breeding facility, and built a 20-stall barn and paddocks. At no time were boarded horses permitted outside of that part of the property.

The IRS determined a deficiency of almost $100,000 against Schlicher, arguing that only one acre of the Clayton property was used for residential purposes.

Schlicher testified that he personally used the hilly portion of the property for horseback riding, hiking, walking and enjoying the unobstructed view of the countryside. During the springtime, the horses he personally owned grazed there. Finding Schlicher to be a credible witness, the Tax Court concluded that only the 7 1/2 acres he fenced off for the boarding and breeding activity was not part of his personal residence; the remaining 43 1/2 acres were used for residential purposes. The court said that residential purposes may include appreciating nature, living in open spaces, hiking, horseback riding and enjoying unobstructed views of the countryside. Under the standard applied in Schlicher, most personal nonbusiness use would qualify as residential use.

If Schlicher were to sell four 10-acre plots, over, say, a two-year period, from the 43 1/2 acres that qualified as residential use, the Sec. 121 exclusion should apply.

In Rev. Rul. 76-541, former Sec. 1034's nonrecognition of gain provisions applied to gains realized by a taxpayer on the separate sale of a house situated on one parcel of land and the sale of a second contiguous parcel later in the same year, as long as both parcels of land were used as the taxpayer's principal residence. Rev. Rul. 76-541 is helpful in interpreting new Sec. 121 for multiple transactions. Rev. Rul. 76-541 cited Bogley, 263 F2d 746 (4th Cir. 1959), in which individual taxpayers acquired 13 acres of land in 1939. They constructed a residence on this acreage and lived there until December 1950, when they moved into a new residence located several miles from the old residence. Prior to Dec. 31, 1950, the tax-payers sold the old residence and three acres of land. The remaining 10 acres were sold in two transactions of five-acre parcels each in June and August 1951. The Court of Appeals reasoned that the 13 acres were part of the taxpayers' old residence; therefore, the character of the remaining 10 acres did not change and remained residential. The IRS accepted this interpretation in issuing Rev. Rul. 76-541.

Under the Taxpayer Relief Act of 1997 (TRA '97), Sec. 121 allows for an exclusion of gain from the sale of a principal residence. Sec. 121 (a) states, "Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more." Sec. 121(b)(1) and (2) state the amount of gain excluded from gross income under subsection (a) with respect to any sale or exchange shall not exceed $250,000 or $500,000 for certain joint returns. Sec. 121(b)(3)(A), however, adds, "Subsection (a) shall not apply to any sale or exchange by the taxpayer if, during the 2-year period ending on the date of such sale or exchange, there was any other sale or exchange by the taxpayer to which subsection (a) applied." Read literally this would seem to imply that, other than the initial sale, multiple sales of a personal residence will not qualify for the Sec. 121 exclusion. However, the House Ways and Means Report to the TRA '97 indicates that the language limiting the benefits to one sale or exchange every two years should be interpreted to refer to one residence every two years:

The exclusion is allowed each time a taxpayer selling or exchanging a principal residence meets the eligibility requirements, but generally no more frequently than once every two years.

The Conference Report goes even further when it specifically sanctions a type of multiple sale within two years:

The conferees wish to clarify that the provision limiting the exclusion to only one sale every two years by the taxpayer does not prevent a husband and wife filing a joint return from each excluding up to $250,000 of gain from the sale or exchange of each spouse's principal residence provided that each spouse would be permitted to exclude up to $250,000 of gain if they filed separate returns.

Therefore, arguably, the enactment of new Sec. 121 still allows multiple sales to qualify as one sale of a principal residence.

In summary, even though Sec. 121(b)(3)(A) allows for only one sale during a two-year period of a principal residence, it might not preclude the continued sale, through the use of multiple transactions, of the same qualifying residential property. Rev. Rul. 76-541 and the Bogley case seem to bolster this argument by allowing multiple sales of a principal residence without changing the property's character. This may allow taxpayers with residences on large tracts of land to maximize after-tax profitability by using multiple sales.

From James P. York, CPA, MS (Tax), Stockton, Cal.
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Author:York, James P.
Publication:The Tax Adviser
Date:Feb 1, 1998
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