Sec. 121 Gain Exclusion on Sale of Principal Residence Cannot Be Marked to Market

In Rev. Rul. 2001-57, the Service ruled that if an individual were to elect under Section 311(e) of the Taxpayer Relief Act of 1997 (TRA '97) to treat his principal residence as being both sold and reacquired on Jan. 2001 for an amount equal to its fair market value (FMV) on that date, he could not exclude the gain resulting from the deemed sale from gross income under Sec. 121.

Background

Under Sec. 1(h)(2)(B) (as amended by TRA '97 Section 311), for tax years beginning after 2000, the maximum capital gain rate for assets held more than five years was reduced from 20% to 18%. The 18% rate generally applies only to assets for which the holding period begins after 2000.

However, under Section 311(e)(1), a taxpayer may elect to treat any capital asset (other than readily tradable stock) or any property used in his trade or business and held on Jan. 1, 2001 as having been sold and reacquired on Jan. 1, 2001 for its FMV on such date. (An election for readily tradable stock will result in the stock being treated as having been sold at its closing price on Jan. 2, 2001, then reacquired at that price.) Under Section 311(e)(2), "[a]ny gain resulting from an election under [Section 311(e)(1)] . . . shall be recognized notwithstanding any provision of the Internal Revenue Code of 1986." Any loss resulting from such an election is disallowed. The election must be made on an asset-by-asset basis on the taxpayer's 2001 return, no later than six months after the return due date, without extensions. Once made for any asset, the election is irrevocable.

Under Sec. 121, a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. The exclusion is allowed each time a taxpayer selling or exchanging a principal residence meets the eligibility requirements, but generally no more than once every two years. To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal residence for at least two of the five years before the sale or exchange.

Ruling

The Service concluded that the Section 311(e) election not only confers tax benefits on the electing taxpayer (a holding period that begins in 2001 and a basis step-up), but also imposes a tax cost (i.e., current recognition of gain resulting from any existing appreciation in the asset). Therefore, excluding the gain from the deemed sale would frustrate the balancing of benefits and burdens. Citing the legislative history of Section 311(e), the IRS ruled that the statutory requirement that gain be recognized notwithstanding any other Code provision precluded application of the exclusion from gross income under Sec. 121, because it prevented the intended consequences of the recognition (taxation of the gain).

From Robert Coplan, Washington, DC