Gates v. Commissioner

I’ve come across the Gates decision several times this past year.

Here are the facts: the gates owned and used a house as their principal residence for 2 years. They thought of remodeling the house, but instead they decided in 1999 to demolish and rebuild. They never moved in to the new house. In 2000 they sold and realized an almost $600,000 gain. They claimed the gain was excludable under the principal residence exclusion.

Let’s address the easy one. Only $500,000 of the gain is excludable. Any excess over that will be taxable.

The big issue is whether the house they lived in was the same house they sold. They had owned and occupied the OLD house for the required two out of five years. Taxpayers argued that the land and improvements should somehow meld, so that occupancy in the former house should carryover to the newly-constructed house because the new house sat on the same land as the former. This is the house into which they never moved, by the way. The Tax Court reviewed decisions in which land was considered part of a principal residence. The Court was greatly pressed to argue from the reverse direction – that the sale of the land would drag along whatever improvements sat on it.

The Tax Court decided this was an argument too far and that the entire gain (of almost $600,000) was taxable.

My take: I doubt there the Gates sought out any tax advice before selling the house. I think that almost any competent tax professional would have sensed that they were pressing the point too far. They could have, for example, moved into the new house while it was being sold. They may not have gotten the full two years in, but they at least would have qualified for the prorated exemption. Alternatively, one wonders what the result would have been if they had left some walls standing. The closer to a renovation – and the further from a new build - the better their argument becomes.