Category: Real Estate; Nontaxable Exchanges
Subject: Principal Residence, Sale of Partial Interest
Title: Effect on Section 1034 Treatment
IRC Sections: 1034
Filename: 1300.html
Date Produced: 02/94

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Facts
Individual Taxpayer (TP) sold a one-half interest in his principal residence to a friend. The value of the house based on the selling price was approximately $234,000. The friend moved in with TP and the two used the house as their principal residence. Both TP and friend contributed funds equally toward a substantial renovation of the home costing approximately $260,000.

Issues
Does the sale of a one-half interest in a principal residence qualify for rollover treatment under §1034? If so, does the substantial renovation qualify as a replacement residence for purposes of IRC §1034.

Answers
Claiming §1034 rollover treatment on the transaction described above appears to be, at the very best, extremely risky. Depending on one's interpretation of the facts, it is highly possible that the renovation would not qualify as a replacement residence. In that case, §1034 treatment would be clearly forbidden. If the renovation qualified as a replacement residence, there is no clear prohibition against the type of transaction set forth above; however, there are several strong arguments that could be made based language in the regulations and on the committee reports surrounding the 1951 enactment of the predecessor to §1034 that the transaction is well beyond the reach of §1034. It is my view that these arguments are extremely potent and would be successful if the matter were litigated.

Discussion
Regulation §1.1034-1(b)(9) provides that purchase of a new replacement residence for purposes of §1034 means, among other things, construction or reconstruction of a residence. Mere improvement not amounting to reconstruction does not constitute purchase of a residence for purposes of §1034. It is not clear what level of renovation of an existing residence is necessary to be considered reconstruction. The regulations do not elaborate, and there are no cases or rulings interpreting this point. Without interpretive guidance, one must assume that an extremely high level of refurbishment would be necessary to meet the reconstruction standard. The term reconstruction would seem to me to imply that the existing structure is either a) unusable without such reconstruction work; or b) will be structurally changed on a wholesale basis. Clearly, others could interpret the term differently.

If TP's renovation of the residence does not rise to the level of reconstruction, then deferral of gain under §1034 would be prohibited. Accordingly, the ultimate conclusion of this matter lies in one's interpretation of the facts. Just how substantial is TP's renovation work with respect to the new residence? Based on the amounts expended for renovation, I gather that the work was quite substantial, perhaps even amounting to a reconstruction of the residence. Again, there is no definitive answer.

If you believe that TP's renovations constitute reconstruction of the residence, it is necessary to address the thornier question of whether sale of a partial interest in a residence qualifies under §1034 in the first instance.

§1034(a) provides for deferral of gain if property used by the taxpayer as his principal residence is sold and property is purchased within a certain time frame and used as the taxpayer's new principal residence. The literal language of the statue is silent as to whether the taxpayer must sell his entire interest in the principal residence in order to qualify under §1034. Since Congress chose not to address the issue directly, it is appropriate to look at the committee reports surrounding the enactment of §1034 in an effort to determine whether there is any indication of Congressional intent in this regard.

§1034, or rather its predecessor under the Internal Revenue Code of 1939, was enacted in 1951. House Report No. 586, 82d Congress, 1st Session 1951-2 C.B. 377-378 refers to a taxpayer who sells a residence and within the specified time period purchases or builds a substitute residence [emphasis added]. It appears from the use of the term "substitute residence", that the taxpayer must sell his entire interest in his old residence in order to qualify under §1034. The regulations reflect this concept, at least indirectly. Regulation §1.1034-1(a) provides for nonrecognition of gain for taxpayers who sell one residence and purchase or build another residence [emphasis added]. Neither passage is absolutely convincing on this matter, but absent anything positive having been said in the committee reports or the regulations to support the idea that a partial interest can be sold, I feel these passages could be extremely damaging to TP's case if this matter were ever litigated.

Finally, there is Revenue Ruling 84-43, 1984-1 C.B. 27, which provides for purposes of §121 that §121 treatment is available to a seller of a partial property interest (such as a life estate) in a principal residence if such interest is the taxpayer's entire interest in the property. While this ruling clearly applies to another section, the concept involved is quite similar to TP's circumstances, and the ruling may provide a clue as to how TP's issue would be viewed by the IRS.