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$500,000 Gain Exclusion Clause

  What Amount Of A Farm’s Purchase Price Can Be Allocated To A Farmhouse For Purposes Of The $500,000 Exclusion From Income On The Sale Of A Residence?  
   
  LAW

Section 121 of the Internal Revenue Code of 1986, as amended (the “Code”) provides that gross income on a jointly filed federal income tax return shall exclude gain to the extent of $500,000 if the gain is realized by the taxpayers from the sale of a principal residence. To qualify as a principal residence under Code Section 121 in the instance of a joint return, at least one of the spouses must have owned the home and used it as his or her home for at least two of the five years preceding its sale. It’s also necessary that a Section 121 exclusion not have been claimed by either spouse during the two year period ending on the date of sale.

ISSUE

Whether the Section 121 exclusion is available with respect to the sale of a farmhouse. The farmhouse was built 5 years ago for $100,000 and the 100 acres surrounding the house is worth $400,000. The selling price for the farm with farmhouse is $500,000. How much of the sales price qualifies for the $500,000 exclusion from income provided by Code Section 121? Just how big can a residence be for purposes of this Section?

ANALYSIS

Recognition of 10 acres constituting a principal residence are common in the case law, Revenue Rulings and the Treasury Regulations governing Section 121. In Rev. Rul. 76-541, 1976-2 CB 246, the IRS applying Code Section 1034, the predecessor tax relief statute relating to the sale of a personal residence, found that 13 acres qualified as the residence where “the taxpayer owned and resided in a house situated on an undivided parcel of land . . .” The ruling cited Bogley v. Commissioner, 263 F.2d 746 (4th Cir. 1959), reversing 30 T.C. 452 (1958) and summarized the case as an instance in which the
. . . individual taxpayers acquired thirteen acres of land in 1939 [and] sold the old residence and three acres of land. The remaining ten acres were sold in 5-acre parcels in June and August of 1951. The United States Court of Appeals reasoned that the thirteen acres intact were part of the taxpayers' old residence and that the character of the remaining ten acres did not change. Thus, the Court held that the gain realized from the sale of the ten acres in June and August of 1951 was entitled to the benefit of the nonrecognition provisions . . . .
Example (3) of the Regulations under Section 121, also dealing with a staggered sale of property, describes a situation qualifying for the $500,000 exclusion which clearly parallels your situation when the initial 10 acre homestead was given to you by Mrs. Nuckols.
Example (3) In 1991 Taxpayer C buys property consisting of a house and 10 acres that she uses as her principal residence. In May 2005 C sells 8 acres of the land and realizes a gain of $110,000. C does not sell the dwelling unit before the due date for filing C's 2005 return, therefore C is not eligible to exclude the $110,000 of gain. In March 2007 C sells the house and remaining 2 acres realizing a gain of $180,000 from the sale of the house. C may exclude the $180,000 of gain. Because the sale of the 8 acres occurred within 2 years from the date of the sale of the dwelling unit, the sale of the 8 acres is treated as a sale of the taxpayer's principal residence under paragraph (b)(3) of this section. C may file an amended return for 2005 to claim an exclusion for $70,000 ($250,000 - $180,000 gain previously excluded) of the $110,000 gain from the sale of the 8 acres.
Treas. Regs. Section 1.121-1(b)(3)(ii)(C)(4).

There are also cases where acreage substantially in excess of 10 acres has been recognized as residential property. For example, in Bennett v. U.S., 8 AFTR 2d 5593, 10/06/1961, the Court found that 65 acres qualified as residential property. In Schlicter v. Commissioner, T.C. Memo 1997-37, the Tax Court found similarly in 1997 that 51 acres were used for residential purposes. In this case, the Court found that “residential purposes may include appreciating nature, living in open spaces, hiking, horseback riding, and enjoying unobstructed views of the countryside.” This is a very expansive concept of residential purposes and is further illustrated by this more extensive selection of excerpts from the opinion.
At trial, the petitioner repeatedly and unequivocally testified that he moved to the Clayton premises, because he appreciates nature, admires unobstructed views of the countryside, enjoys living in open spaces where he can hike and ride horseback, and ultimately desires to live the rest of his life there. We find petitioner's testimony to be credible. . .

Petitioner enjoys living in Clayton, because it is a secluded rural area where he can be close to nature. . . . Petitioner lived with his girlfriend, Patsy Lyons, at both the Livermore and the Clayton residences. Each of them rides horseback and has ridden petitioner's personal horses on the steeply-hilled portion of the Clayton property, and on the plain. Petitioner uses the upper wooded area for hiking.

Petitioner and his girlfriend, Patsy Lyons, have used the upper, steeply hilled portion of the Clayton property for horseback riding, hiking, walking, and simply to enjoy the unobstructed view of the countryside and Mount Diablo. During the springtime petitioner's personal horses graze up there. When petitioner originally built his principal residence on the Clayton property, he was considering building it in the upper wooded area. . . . .

Whether or not property is used by a taxpayer as his residence depends upon all the facts and circumstances in each case, including the good faith of the taxpayer. Thomas v. Commissioner, 92 T.C. 206, 243 (1989)

. . . in the instant case, the petitioner regards and uses all of the Clayton property as his residence, except for the portion allocated to his business. At trial, the petitioner repeatedly and unequivocally testified that he moved to the Clayton premises, because he appreciates nature, admires unobstructed views of the countryside, enjoys living in open spaces where he can hike and ride horseback, and ultimately desires to live the rest of his life there. We find petitioner's testimony to be credible.

.. . petitioner enjoys solitude and credibly testified that he did not purchase the Clayton property for investment purposes, but rather as a place where he could live “the rest of his life,” untroubled by close neighbors.

Accordingly, we find that petitioner held the remaining 43-1/2 acres as his residence and not for investment. Residential purposes may include appreciating nature, living in open spaces, hiking, horseback riding, and enjoying unobstructed views of the countryside. In fact, this is quite common in the Western portion of our country, as in Clayton, California, where land is more plentiful. Nothing in section 1034 prohibits us from finding that such use constitutes “significant use” for residential purposes. Accordingly, we find that petitioner has met his burden of proving that he used the remaining 43-1/2 acres of the Clayton property as his residence. (emphasis added)
This very expansive treatment of residential purposes provides some basis for maintaining that a large number of undeveloped acres are part of the residence. However, to the extent acreage has been used for business purposes, it cannot qualify as part of the residence when determining what amount of the purchase price of a farm can be allocated to a farmhouse.

 
 
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