Understanding What IRS Doesn't Say on Section 1038 - Exclude Gain Sale of Home and Recognize Gain on Repossession

It is not enough to know what the Internal Revenue Code says; understanding what it doesn't say is equally as important. There are plenty of gains one can miss if what's said and unsaid on Section 1038 is not fully comprehended. 

Forbes illustrates this notion best using the recent 8^th Circuit's decision in DeBough. In the DeBough case, the taxpayer sold his residence for $1.4 million in 2007. The buyer paid $250,000 as down payment, and another $250,000 later that year. The buyer agreed to pay the rest of the $900 over several years. DeBough's earned a total gain of $620,000, but using the popular Section 121, DeBough excluded $500,000 from his taxable income.

Section 121 allows a taxpayer who has used the house they owned for two years of the previous five years as his main residence to exclude up to $500,000 from the gain. This means DeBough only has $120,000 worth of taxable gain by applying Section 121. DeBough was able to collect a total of $505,000 from the buyer, until the buyer defaulted on his balance. DeBough recognized only $56,920 gain from the cash he received. DeBough repossessed the house and held it for some years without reporting any gain from the repossession and this caught the attention of the IRS.

The lesser known Section 1038 of the Code which states that, despite being the acquirer of the property, DeBough is not allowed to take bad debt deduction and may be required to recognize gain upon the repossession of the previously sold property. Section 1038 controls the tax consequences when a taxpayer sells a house to a buyer and takes back the purchase-money note, and the taxpayer reacquires the property later on in full or partial satisfaction of the note.

This means DeBough wasn't able to recognize what the code doesn't say. The Tax Court was applying what it "doesn't say," which is the lesser known Section 1038. Because of this, DeBough was forced to recognize the $449,080 gain on the repossession of the real property.