In Part 1, we discussed the notices the IRS gives when it believes the taxpayer has failed to report as taxable income the gain on the sale of a personal residence. Part 2 of this article focuses on the law of taxation of personal residences that the taxpayer can use to rebut the IRS’s attempted taxation.
In responding to the IRS notice of additional tax due for the sale of a personal residence, the taxpayer should keep in mind the following defenses.
- Only the gain on sale may be taxable. Generally, gross income includes total income received from all sources. However, in calculating the income generated from the sale of property, a taxpayer’s basis in the property is subtracted from the proceeds received in order to obtain the amount recognized by the tax taxpayer that could, if an exclusion does not apply, be subject to taxation. It is my experience that the notices the taxpayer receives from the IRS is for the total amount of the sale of the personal residence. The notices do not take into account the taxpayer’s basis in the property and costs of sale. It is critical that the taxpayer then provide information to the IRS showing that the gain on sale is less than the sales price.
- The gain on sale of the personal residence is excluded from income under certain conditions. Under IRC § 121, gross income does not include the gain from the sale of a personal residence if the taxpayer has owned and used the personal residence in two of the past five years. The amount of exclusion is limited to $250,000 for an individual or $500,000 for spouses. The exclusion under IRC § 121 will often render the entire gain on sale as nontaxable.
- If the personal residence hasn’t been held for two of the last five years, there are a number of exceptions that permit the taxpayer to exclude all or a percentage of the gain on sale if the sale was due to the change in the place of employment, military service, and illness.
Practice Point: In responding to an IRS notice of additional taxable income due to the sale of a personal residence, a taxpayer will want to respond to the IRS setting forth legal arguments, including those above, and documents to demonstrate basis in the property, use of the property as a personal residence, and other documents to show that the sale proceeds are not taxable.
Taxpayers who receive notice of taxable income after a sale of a house are urged to contact Jared Le Fevre to discuss how to exclude the proceeds from taxable income and how to respond to the IRS.
About the author: Jared M. Le Fevre is a tax attorney and partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.