1. Tom and his wife Janet Jones purchased their personal residence and 45 acres of land in 1966 for $25,000. On September 15, 2012, the taxpayers agreed to sell the property for $1,200,000. The taxpayers sold the property to Martin Short for cash of $100,000 and the balance to be paid over 10 years at an annual interest rate of 5% with the first installment due on January 1, 2013.

The gain was calculated as follows:

Original Purchase Price                            $25,000
Improvements                                           $322,000
Total Cost                                                   $347,000

Sales Price                                                   $1,200,000
Total Cost                                                    $347,000
Realized Gain on Sale                                 $853,000
Section 121 Exclusion                                  $500,000
Total Gain to be Recognized                     $353,000

Recognized Gain in 2012 using the installment sale method $29,416 (100,000 x(353,000/1,200,000)

In 2013, Martin Short defaulted on the loan and did not make any payments to Tom and Janet Jones for the purchase of the home. The taxpayers then reacquired the property in December 2013 and incurred $10,000 in legal costs to cancel the original sale. They did not have to return the $100,000 back to Mr. Short.

The taxpayers subsequently sold the property in 2015 to a new buyer for a total cash price of $1,000,000. However, the IRS has sent notice for 2012 denying the original $500,000 exclusion of gain under section 121 and therefore a tax deficiency of $41,667 for 2012. The taxpayers never reoccupied the residence and only held the property for sale after reacquiring it in 2013.

Answer the following questions:
1. Were they correct in the past?
2. Are they eligible now?

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1. Were Tom and Janet Jones correct in the past?

The special rules for joint returns under U.S. Code § 121 set a limit of $500,000 for certain joint returns. Based on this provision, Tom and Janet Jones were correct to claim exclusion on the gain from the sale of their home when they sold it to Martin Short in 2012. The facts of the case indicate that the property was the couple’s personal residence from the time they purchased it until the time they sold it to Mr. Short. Since both Tom and Janet had been living in the property prior to selling it, they met the ownership requirements outlined in subsection (a) of the U.S. Code § 121 (IRS, 2015).

As a married couple filing jointly, Tom and Janet passed the eligibility test, and could exclude up to $500,000. None of the automatic disqualification requirements applied to the couple as of the closing date of the sale to Mr. Short....
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