By Robert J. Bruss

Are home sellers entitled to the $500,000 tax exemption? Inman News James and Jean owned their home in northern Wisconsin between 1993 and 1998. They also owned a home in Georgia between 1993 and 1996. When they sold it, they used the now-repealed Internal Revenue Code 1034 "rollover residence replacement rule" to defer profit tax by purchasing an Arizona replacement principal residence of equal or greater cost in 1996.

In 1997, Congress enacted the Taxpayer Relief Act. It included new Internal Revenue Code 121, the $250,000/$500,000 principal residence sale exemption. To qualify, a home seller must have owned and occupied their principal residence an "aggregate" two of the five years before its sale.

In 1998, James and Jean sold their Wisconsin home. They paid a $45,009 capital gain tax on its sale.

But in January 2001, they filed an amended income tax return IRS form 1040X to claim a $45,009 tax refund. The IRS denied the refund.

James and Jean sued for a $45,009 tax refund. According to their affidavit, they spent a total 847 days in their Wisconsin home between 1993 and its sale in 1998, 563 days in their Georgia home before its sale, and 375 in their Arizona home. They generally resided in their Wisconsin home during the summer months.

The home sellers kept a car at each home and had accounts at banks near each location. Although James and Jean filed state income tax returns in Georgia, and later in Arizona after buying a home there, they never filed Wisconsin income tax returns.

The IRS cited its regulation 1.121-1(b)(2), which says the relevant factors for determining a principal residence are where the taxpayer spends a majority of the time during each year; the taxpayer's place of employment (James and Jean are retired); place of abode of family members (their children are grown); address listed on income tax returns; driver's licenses; auto registrations; voter registrations; addresses for bills and correspondence; banking relationships; and membership in religious and/or recreational organizations.

After the IRS denied their tax refund, James and Jean took their dispute to the U.S. District Court.IF YOU WERE THE JUDGE would you order the IRS to refund $45,009 capital gain tax paid on the sale of James and Jean's Wisconsin home?

The judge said NO!

There is no question James and Jean meet the "aggregate" two out of the last five years ownership and occupancy tests for their Wisconsin home, the judge began. However, to claim the Internal Revenue Code 121 home sale tax exemption up to $250,000 (up to $500,000 for a married couple filing jointly), the property must be the principal residence of the seller(s), he emphasized.

During the five years before the sale of their Wisconsin home, the judge noted, James and Jean used the old now-repealed Internal Revenue Code 1034 "rollover residence replacement rule" to defer tax on the sale of their Georgia home by purchasing their Arizona principal residence of equal or greater cost.

This tax deferral indicates James and Jean considered their Georgia and Arizona homes their principal residences, the judge explained. Also, during the five years before the sale of the Wisconsin home, each year James and Jean spent more time annually in each of their other homes, he noted.

Although the Wisconsin home was larger than either of the other homes in both size and market value, that does not overcome the other facts indicating it was not the principal residence of James and Jean, the judge ruled. Because James and Jean showed minimal Wisconsin home contacts as outlined in the IRS regulation, the sale of their Wisconsin home was not their principal residence and they are not entitled to the Internal Revenue Code 121 capital gains tax exemption up to $500,000, the judge concluded.

Based on the 2003 U.S. District Court ruling in Guinan v. U.S., 2003-1 USTC 50475.