Exclusion of Capital Gain from Sale of Personal Residence Does Not Always Apply
Under §121, if married taxpayers own and use property as their principal residence for at least two of the ﬁve years ending on the
date of sale, they can exclude up to $500,000 of capital gain on a joint return. However, I do not believe the terms “property” and “principal residence” are not deﬁned in the Code or regulations.
Based on legislative history, it can be concluded that Congress intended the terms “property” and “principal residence” to mean a house or other dwelling unit in which the taxpayer actually resided. For example, the sale of land alone may qualify for the exclusion if the taxpayer sells the dwelling unit within two years before or after the sale of the land.
However, the exclusion only applies if the dwelling unit the taxpayer sells was actually used as his or her principal residence for two out of ﬁve years ending on the date of sale.
It can be argued that demolishing and rebuilding a house is no different than remodeling a house based on the ambiguity in determining if there is some level of remodeling that ‘restarts’ the clock as it were in regards to occupying the property for capital gains purposes. What if you demolishes the house but not the foundation and live in a tent on the property during the construction effort? Are you remodeling or rebuilding? It can be difficult to ascertain. The best bet is to live in the house for 2 years before selling it.
Another tax treatment to consider if you demolish and rebuild, treat the original house as being sold for zero dollars when demolished with the basis of the house going to the land and apply §121 to a subsequent sale of the land and new house.