Tax question on selling principal residence

[Paul Clements]

(I'm copying this over from the buying/selling forum)

I've lived in a home for 20 years (it's a 50 year old, 1200 sq ft manufactured home, basically a double-wide trailer, that has very dated decor, drop ceiling, and in fair condition) and it's currently listed for sale. It's paid off. I inherited the land and home so I have little cost basis.

I have an offer from the state to buy the land for conservation purposes for $220k, but I'd have to demolish/remove the house and 3 large garages, several small sheds in disrepair, remove septic system, well, foundation of house etc. Two of the barns are cinderblock, one is wood. I also have a 16 panel solar array that's 5 years old that I could sell components of for maybe $5k with inverter batteries etc. I could also potentially sell off the home and a buyer could transport it elsewhere. Not sure how much I could get for it, maybe $10-15k since the moving costs would be high. So at that point I'm at about $235k. Then I'd probably have to pay about $30k to clear the land of all buildings and debris. So I'm back down to $205k. A lot of these are ballpark, offhand estimates and I have yet to verify them.

I also have an offer to buy the property as is for $170k. This is way lower than the asking price, but the highest offer after 2 years on the market. The reason the asking price is where it is for the home condition is because it's a 20 acre lot, some of which is wetlands but has several acres of good land, and it's in a fairly good location. If I demolish or sell off the manufactured home and then sell the land to state, can I claim the sale proceeds as principal residence since I lived on the land previously? or does the sale/demolition nullify that and turn it into a land sale, in which case the $225k may end up being less than the $170k sale of land with the home (minus agent commissions), which would be tax-free.

I know this is a pretty unusual scenario, but any help is appreciated. I have elsewhere I could live for a reasonable price temporarily, while the demolition occurred.

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(Here is a response I received on the other forum)

This is interesting...

Let's wait for some more professional opinions, but the sec121 exclusion rule is having having lived on the property as your primary residence 2 of the past 5 years. So, after you move out, you have 3 years to demolish everything and transfer it to the State. The condition/use of the property shouldn't matter. Just your sales price and cost basis.

Good luck.

This was my response to that:

That's a good point to bring and it may well provide a loophole, I thought it was straight 5 years not 2 of 5.

The complication though for me is whether the land sale would still treated as part of a residence sale, or would the residential link to/nature of the land cease to exist upon demolition. The 2 of 5 rule would be met, but my question is whether IRS considers the sale of vacant land (that I'd no longer be living on) 'part of' a home/residence sale, or would just exempt the very small amount I might receive from selling the manufactured home.

For what may or may not be a relevant comparison, if I sold the contents, fixtures, etc of my house before I sold the actual house, I'd imagine the contents sale would be taxable, but the sale of land and structure not. But if I sold it all together, house with contents and contents not separately valued, I'm guessing none of it would be taxable (within reason of course/assuming absence of fraud).

A similar scenario that might occur is when a house burns down. The owner is reimbursed by insurers then decides to demolish the remains and sell the land. I'm guessing the insurance proceeds there are not taxable, but the land sale is.

[Eamonn McElroy]

The way that I'll explain the concept, from a high level, would be that the dwelling unit would need to be disposed proximate to the sale of the land that is subjacent to the dwelling unit if the gain on the sale of the land is to be excluded under Sec 121.  A demolition is a disposition for zero dollars of consideration, and I am comfortable with the position that if a dwelling unit is demolished or destroyed, and the subjacent land is sold thereafter within the time confines of Sec 121, the land qualifies for the Sec 121 exclusion as long as the prior dwelling unit would have met the ownership and use requirements under Sec 121 notwithstanding the demolition or destruction.  There's really more to it than that, but it would take 10-15 minutes worth of talking to fully explain, which is a little too much for a forum post.

The sale or exchange of the dwelling unit requirement that you're reading in both the majority and the dissent of Gates is in effect an anti-abuse rule to prevent someone from engaging in behavior such as: buying land, putting a mobile home on it, then moving the mobile home to a new lot and selling the old lot every couple of years while utilizing the Sec 121 exclusion on each lot sold.  In that situation, the dwelling unit is never disposed, and that is the essence of the dynamic you're trying to examine.

Now, with the situation at hand, you're talking about a lot more than just scrapping the mobile home, so the optimal answer given the facts and circumstances would depend on a conversation with a tax advisor who excels in this area.  And I'd reiterate, that if you want to keep things simple, just sell it as-is for the lower price.  That's less risk and higher probability that the property qualifies for the Sec 121 exclusion.

Again, it's my opinion that the majority in Gates is offbase.  That they got it wrong.  It happens, that's why we have appeals.  The dissent is really the best part of that case.  But even then, Gates is distinguishable on its face from the facts in your OP.  You're not going to find the answer for your situation in Gates, just the overarching remedial intent of Sec 121.