Reduced exclusion possible in home sale: safe harbors for taxpayers not meeting the use/occupancy rules.

In today's hot housing market, many taxpayers are selling their residences and moving. The tax code aids this endeavor: Under IRC section 121(a)

and (b), taxpayers can exclude up to $250,000 of the gain on the sale or exchange of a home ($500,000 for certain joint returns) if they (1) owned and used the property as a principal residence for at least two of the previous five years ending on the sale or exchange date and (2) have not used the exclusion in the past two years. For taxpayers not meeting these strict requirements, a reduced exclusion may be available if safe harbors are met; CPAs should become familiar with these rules.

OVERVIEW

Taxpayers not meeting the strict occupancy and use requirements described above still may qualify for a reduced maximum exclusion if the residence sale or exchange was due to a change in place of employment, health or unforeseen circumstances; final regulations issued in 2004 explain how and when sellers may qualify and provide safe harbors. Even if a safe harbor is not met, taxpayers may qualify if they can establish, under regulations section 1.121-3 (b), that the sale was "primarily related" to the aforementioned reasons.

EMPLOYMENT

Under regulations section 1.121-3(c)(1) and (2), a sale or exchange by reason of a change in place of employment occurs when the taxpayer owns and uses the property as a principal residence and the qualified individual's (QI's) new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment. If there was no former place of employment, the distance between the QI's new job and the residence sold or exchanged must be at least 50 miles. The regulations define employment and QI for this purpose.

HEALTH

Under regulations section 1.121-3(d), a sale or exchange by reason of health occurs when it allows a QI to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury, or to obtain or provide medical or personal care for a QI suffering from a disease, illness or injury. While a sale or exchange merely for general health or well-being does not qualify, regulations section 1.121-3(d)(2) states a sale or exchange resulting from a physician's recommendation (as defined in IRC section 213(d)(4)) does.

UNFORESEEN CIRCUMSTANCES

Regulations section 1.121-3(e) allows a reduced exclusion if the primary reason for the sale or exchange is the occurrence of unforeseen circumstances, defined as an event that the taxpayer could not reasonably have anticipated before purchasing and occupying a residence. Regulations section 1.121-3(e)(2) lists specific-event safe harbors that must occur while the taxpayer owned and used the residence.

CONCLUSION

The final regulations on the sale or exchange of a principal residence allow taxpayers a reduced gain exclusion amount if certain requirements are met. For more information, see the Tax Clinic, edited by Frank O'Connell, Jr., in the September 2005 issue of The Tax Adviser.

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