IRC Sec. 121 allows a taxpayer age 55 or older to elect a one-time exclusion of up to $125,000 of gain on the sale of his or her principal residence. The residence must be owned and so used by the taxpayer for three of the five years ending on the date of the sale. IRC Sec. 121 does not define principal residence, nor does IRC Sec. 1034, which concerns the deferral of gain on the sale of a principal residence.

In 1940, O.Z. and Gertrude Roy purchased 100 acres of land in Louisiana and constructed their home on it. None of the land was used commercially after the 1940s. The Roys unsuccessfully attempted to sell their residence to pay medical bills in the late 1980s.

In 1988, they transferred title to the house and 32 acres of the land to their son, Larry, for $18,000, which produced a $9,000 gain. The Roys retained the right to continue living in the house for life. Larry did not pay his parents the $18,000, but he orally promised to help care for them instead. The Roys, assisted by volunteers, completed part of Form 2119 Indicating the selling price, basis, and exclusion of the gain under IRC Sec. 121. In 1989, the Roys sold the remaining land to an unrelated party for $39,600, resulting in a $31,391 gain. Using a professional tax service, they also elected to exclude this gain under IRC Sec. 121.

The IRS disallowed the 1989 election because the Roys had previously elected, and had not revoked, the 1988 election. (The election can be made, or revoked, anytime within the period ending on three years after the due date of the return.) Alternatively, the IRS argued that the 1989 sale did not qualify because it did not include the house. The Roys argued that both transactions combined constituted one sale of their principal residence.

The Tax Court first ruled that the house and all of the land combined constituted the Roys' principal residence. Next the court ruled that two separate transactions could constitute one sale of a principal residence under IRC Sec. 121. However, the court then ruled that the Roys did not qualify for the exclusion because they had not sold their house. Since the Roys retained current use of the house, they had sold only a future interest in it and had not transferred the "benefits and burdens of ownership" to the purchaser. Previous case law has established that if the house is not sold, there is no sale of a "principal residence" under IRC Sec. 1034. Since Reg. Sec. 1.121-3(a) specifies that "principal residence" means the same in IRC Sec. 121 as in IRC Sec. 1034, the result is the same under IRC Sec. 121. What Roy adds to this analysis is that the house is not sold if merely a future Interest is transferred.

The Tax Court also ruled that the 1988 election was invalid because the Roys omitted much of the information required by Reg Sec. 1.121-4(b). The court did not specify exactly which information was omitted, but noted that part I of the Roys' 1988 Form 2119 was not filled in. Also, the Tax Court raised the issue, but did not rule, on whether the 1988 transaction was a gift rather than a sale, since Larry never paid his parents the $18,000.

The Tax Court's ruling in Roy prevents elderly taxpayers who sell their principal residence to raise money from electing the IRC Sec. 121 exclusion while continuing to live in their home. However, one approach that probably would allow taxpayers to achieve these objectives is to sell the residence in a bona fide sale and to rent the residence at Fair market value from the purchaser. However, the benefits and burdens of ownership, as described in Awalt v. Commissioner, T.C. Memo 1987-42, must be transferred to the purchaser. Clearly, the safest way to ensure a successful IRC Sec. 121 election is for the seller to move out of the home.

Source: Roy v. Commissioner, T.C. Memo 1995-23 (January 18, 1995).