We all have financial ups and downs in life. Some of these ups and downs are due to circumstances beyond our control. Be it good luck, bad luck or something else. Many of these circumstances are not foreseeable.
There are also circumstances that are due to our own making. Be it poor financial decisions or actions. These circumstances are often foreseeable–particularly if one takes a step back and reflects on the big picture.
Financial decisions have tax consequences. Tax follows finance. This raises questions as to whether taxpayers should get a break on the tax consequence if they have financial difficulties. If so, when? When there is an unforeseen circumstance that is beyond the taxpayer’s control? What about a foreseeable circumstance that is within the taxpayer’s control?
The United States v. Forte, No. 2:18-cv-00200-DBB (D. Utah 2021) case deals with this type of issue in the context of the exclusion of gain on the sale of a primary residence.
Facts & Procedural History
The taxpayers are husband and wife. They owned a home that they lived in for five years. They sold the first house on seller-financing in late 2005.
The taxpayer purchased a lot in 2003 and started constructing a new home on the lot. They moved into the new home in late 2005. They also purchased the lot next door to their new house to protect the view from their new house.
The interest rate on the new house was high and the taxpayers were not able to refinance the loan due to their credit. At the same time, the taxpayers were not able to fully collect the seller-financing payments from their first house in 2005.
A family friend apparently took out a loan against the new house to help. In 2007, the taxpayers sold the new property for a substantial gain.
The IRS pulled the tax returns for audit. The case ended up in U.S. District Court. Both parties moved for summary judgment arguing about whether the gain from the sale of the new house in 2007 could be reduced pursuant to I.R.C. § 121.
About the Section 121 Exclusion
Section 121 allows taxpayers to exclude gain on the sale of their principal residence. To qualify, the taxpayer generally has to own the property for five years and use the property as their principal residence for two of those years.
The exclusion also allows taxpayers to exclude a portion of their gain if they are not able to meet these timing rules. This is limited to situations where there is a “change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.”
What Counts as Unforeseen Circumstances?
What counts as “unforeseen circumstances”? The regulations provide some hints:
A sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. A sale or exchange by reason of unforeseen circumstances … does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.
The regulations go further and provide safe harbors where an unforeseen circumstances are deemed to have occurred:
(i) The involuntary conversion of the residence.
(ii) Natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under section 165(h)).
(iii) In the case of a qualified individual described in paragraph (f) of this section –
(B) The cessation of employment as a result of which the qualified individual is eligible for unemployment compensation (as defined in section 85(b));
(C) A change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household (including amounts for food, clothing, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary to the production of income, but not for the maintenance of an affluent or luxurious standard of living);
(D) Divorce or legal separation under a decree of divorce or separate maintenance; or
(E) Multiple births resulting from the same pregnancy.
The regulations include the following example:
H works as a teacher and W works as a pilot. In 2003 H and W buy a house that they use as their principal residence. Later that year W is furloughed from her job for six months. H and W are unable to pay their mortgage and reasonable basic living expenses for their household during the period W is furloughed. H and W sell their house in 2004. The sale is within the safe harbor of paragraph (e)(2)(iii)(C) of this section and H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).
Thus, financial difficulties due to loss of a job or self-employment status can qualify for the safe harbor and is deemed to be unforeseen circumstances. But what about general financial difficulties that are not tied to a job loss? That brings us back to this case.
Financial Difficulties as Unforeseen Circumstances
In the present case, the court opinion suggests that the taxpayers’ financial difficulties were due to two events: (1) not being able to collect seller-finance payments from the prior sale of their home and (2) purchasing property with a high interest rate that was not sustainable given the taxpayers’ finances and/or credit.
The IRS focused on the second point. It basically argued that the taxpayers’ financial problems were known or foreseeable and of their own doing:
Plaintiff’s argument is that because the Fortes “were aware of their financial difficulties” and made those difficulties worse by purchasing Lot 3, they cannot claim it was unforeseeable they would sell the home prior to living in it for two years.
The court noted that this may be the case, but it also noted that the taxpayers might be able to show that the first point, the inability to collect seller-finance payments, may be unforeseen circumstances.
The other factor that is not addressed in the opinion is that the second house was sold for a gain. Thus, taxpayers took a financial risk, weathered the financial difficulty long enough, to sell the property for a gain. While they may have been cash poor, apparently their wealth was increasing with the value of the second house that they sold. It is not clear whether this cash-poor status while their wealth was increasing due to the house price increasing should really qualify. The rules do not address it. Perhaps this tax litigation case will eventually provide an answer.
This case shows that there are other events that can count as “unforeseen circumstances” for excluding gain on the sale of a primary residence.
General financial difficulties may qualify if there are some identifiable events that one can point to. By identifying the events, the taxpayer (and the IRS) can assess whether those events are unforeseen or foreseeable.
Taxpayers filing tax returns that exclude gain based on “unforeseen circumstances” should plan their taxes in advance and document the events.