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Personal residence gain exclusion: unforeseen circumstances safe harbors.

Under Sec. 121(a) and (b), taxpayers can exclude up to $250,000 of the gain on the sale or exchange of their principal residence ($500,000 for certain joint returns). However, they must have 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. Also, under Sec. 121(b)(3), taxpayers can use this exclusion only if they have not used it in the last two years.


On Aug. 13, 2004, the IRS issued final regulations on (1) the gain exclusions and (2) Sec. 121(c)'s special rules for taxpayers who do not meet the two-out-of-five-year test or the two-year limit. Under the latter provision, taxpayers may still qualify for a reduced maximum exclusion if the sale or exchange was due to a change in place of employment, health or unforeseen circumstances; the regulations provide safe harbors to qualify. If a safe harbor is not met, taxpayers might still be able to qualify if they can establish that the sale was "primarily related" to the aforementioned reasons, under Regs. Sec. 1.121-3(b).

Safe Harbors

Employment: According to Regs. Sec. 1.121-3(c)(1) and (2), a sale or exchange is by reason of a change in place of employment if it occurs when the taxpayer owns and uses the property as a principal residence, and the qualified individual'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 qualified individual's new place of employment and the residence sold or exchanged must be at least 50 miles. Regs. Sec. 1.121-3(c)(3) defines "employment" as commencement with a new employer, continuation with the same employer or, for self-employed taxpayers, commencement or continuation of self-employment. Regs. Sec. 1.121-3(f) provides that a qualified individual is a:

1. Taxpayer;

2. Taxpayer's spouse;

3. Co-owner of the residence;

4. Person whose principal place of abode is in the same household as the taxpayer; or

5. Person bearing a relationship specified in Sec. 152(a)(1)-(8) (without regard to qualification as a dependent) to a person described in items 1-4 above, or a descendant of the taxpayer's grandparent.

Example 1: A is employed by T at T's South Bend, IN office. She purchased a house in June 2002 that is 35 miles from there. In May 2003, A began a temporary assignment at T's Oakbrook, IL office, which is 75 miles from her house, and moved out of the house. In June 2005, A was assigned to work in T's Sydney, Australia office. She sold her house in August 2005 as a result of the new assignment and moved to Sydney.

The sale of the house is not within the safe harbor by reason of the change in place of employment from South Bend to Oakbrook, because the Oakbrook office is not 50 miles farther from A's house than was the South Bend office. Further, selling the house to move to Sydney is not within the safe harbor, because A had not been living in her principal residence when she moved to Sydney. However, A is still entitled to claim a reduced maximum exclusion under Sec. 121(c)(2) because, under the facts and circumstances, the primary reason for the sale is the change in her place of employment.

Health: Regs. Sec. 1.121-3(d) provides that a sale or exchange is by reason of health if it will allow a qualified individual 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 qualified individual suffering from a disease, illness or injury. While a sale or exchange merely for general health or well-being does not qualify, Regs. Sec. 1.121-3(d)(2) states that a sale or exchange resulting from a physician's recommendation (as defined in Sec. 213(d)(4)) does qualify.

Example 2: D and E purchased a home in 2004 to use as a principal residence. Their daughter, F, suffers from a chronic illness that requires routine medical attention. Later that year, F began a new medical treatment at a hospital 150 miles away from home. In 2005, D and E sell their home so that they can be closer to the hospital to facilitate F's treatment. Because, under the facts and circumstances, the primary reason for the sale is to support the treatment of F's illness, D and E can claim a reduced maximum exclusion under Sec. 121(c)(2).

Unforeseen circumstances: Regs. Sec. 1.121-3(e)(1) 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. There are specific-event safe harbors that must occur during the period the taxpayer owned and used the residence as a principal residence, under Regs. Sec. 1.121-3(e)(2):

1. Involuntary conversion of the residence;

2. A natural or man-made disaster, or act of War or terrorism resulting in a casualty to the residence.

3. Any of the following occurring to a qualified individual:

* Death;

* Termination of employment for which the qualified individual is eligible for unemployment compensation;

* Termination of employment resulting in the inability to pay living and housing costs;

* Divorce or legal separation under a decree of divorce or separate maintenance; or

* Multiple births from the same pregnancy.

Although receiving commentary on the issue, the IRS chose not to include marriage, bankruptcy of the taxpayer's employer (not resulting in the loss of the taxpayer's employment) and adoption, as specific-event sate harbors under the unforeseen circumstances exception. Gain also cannot be excluded or limited if the taxpayer's primary reason for selling the residence is a preference for a different residence or improvement in financial circumstances.


Under Regs. Sec. 1.121-3(g)(1), computation of the reduced maximum exclusion is calculated by multiplying the maximum dollar limit ($250,000 or $500,000) by a fraction. The numerator of the fraction is the shortest of the following: 1. The period that the taxpayer owned the property during the five-year period ending on the sale or exchange date;

2. The period that the taxpayer used the property as a principal residence during the five-year period ending on the sale or exchange date; or

3. The period between the date of a prior sale or exchange of property for which the taxpayer excluded gain under Sec. 121, and the current sale or exchange date.

The numerator of the fraction may be expressed in days or months. The denominator is 730 days or 24 months (depending on the measure of time used in the numerator).

Example 3: A single taxpayer, C, purchased a home in January 2004 and sold it in December 2004 because of a change in employment. C has not excluded gain under Sec. 121 on a prior sale or exchange of property in the last two years. Thus, C is eligible to exclude $125,000 of the gain from a sale or exchange of the home (12/24 x $250,000).


The final regulations on the sale or exchange of a principal residence will allow taxpayers a reduced exclusion amount if certain requirements are met.

From Nick HF Hildabridle, and Sami D.T. Miller, South Bend, IN
COPYRIGHT 2005 American Institute of CPA's
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Author:Miller, Sami D.T.
Publication:The Tax Adviser
Date:Sep 1, 2005
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