Comments on Proposed Regulations Under Section 121

Executive Summary

In general, we find the proposed regulations to be very clear and helpful. The use of many examples is helpful. We also appreciate the Service officially stating in regulations that the estate of a bankrupt individual may use the Section 121 exclusion (an administrative position that was previously stated only in an Action on Decision).

Individual members of the ABA Section of Taxation and the Standing Committee on Legal Assistance for Military Personnel have made suggestions for changes to Sections 1034 and 121 in the past several years. Where appropriate to the proposed Section 121 regulations, we restate in this letter, the suggestions made in prior submissions and resolutions, along with our other comments on the proposed regulations.

A summary of our recommendations is as follows:

1. Better guidance is needed on the identification of the property that is the principal residence. The regulations should state that in identifying the property that constitutes a residence for Section 121 purposes, the taxpayer’s intent and actual use should be considered. The size and nature of a property should not be determining factors.
    
2. Clarification is needed to provide that vacant land resulting from destruction of a principal residence may be a principal residence for Section 121 purposes.
    
3. The final regulations should reflect that concurrent ownership and use of more than one residence during a calendar year is contemplated by the statute. The proposed regulations assume that a person cannot have more than one principal residence per calendar year unless there has been a sale of an old home and purchase of a new home. In Example 10 in Prop. Reg. §1.121-1(f), where a person uses a home in New York for 7 months during the year and a Florida home for 5 months, nothing in Section 121 prohibits treating each home as a principal residence during the time it is used. During the year, the homeowner would accumulate 7 months of use under Section 121 for the New York home and 5 months of Section 121 use on the Florida home. This treatment puts this taxpayer on par with an individual who, during a 5-year period, uses a New York home as a principal residence from January 1, 1998 to December 31, 1999, and then uses a Florida home from January 1, 2000 to December 31, 2001. Section 121 does not appear intended to limit taxpayers to accumulating months of "use" during a single calendar year on only one home.
    
4. Medical care should constitute a temporary absence.
    
5. Absence on military duty should suspend the 5-year period or constitute a temporary absence.
    
6. A safe harbor should be added to allow minor use of a residence for rental or office in the home to still be treated as use of a residence (with the taxpayer forgoing depreciation on such minor rental or office use).
    
7. "Unforeseen circumstances," as used in Section 121(c)(2) should be defined broadly to encompass the many types of personal situations that may cause an individual to unexpectedly sell a home that has been owned and used for less than 2 years.
    
8. Guidance on the forms of ownership of a residence that qualify for the Section 121 gain exclusion should be provided.
    
9. Modification to the gain characterization rules of the Section 469 regulations is needed to treat depreciation recapture gain under Section 121 as passive activity gross income if the rental was a passive activity.
    
10. Prop. Reg. §1.121-4(b)(2) should be modified to state that if a divorce or separation instrument grants use of the residence to one spouse , the other spouse, who maintains an ownership interest in the residence, should continue to be treated as meeting the Section 121(a) use requirements without regard to the manner in which the spouse granted use of the residence actually uses the residence.
     
11. Prop. Reg. §1.121-4(b)(2), pertaining to Section 121(d)(3)(B), should be expanded to allow for a divorce or separation instrument to give retroactively the right to use the residence to the spouse residing there.
     
12. The final regulations should provide that Section 121 overrides Section 1041 to the extent it would operate to exclude gain on sale of a residence between spouses.
     
13. The final regulations should include a reference to Section 1016(a)(7) relating to basis of a home for which gain was previously deferred under old Section 1034. Also, because former Section 1034(e) is not readily available for reference (Section 1034 having been repealed), its text should be included in the Section 121 regulations.