Planning Opportunities with the Sec. 121 Partial Exclusion

By Robert B. Cockrum and María T. Cabán-García


  • A taxpayer can exclude gain up to $250,000 ($500,000 for married taxpayers filing jointly and surviving spouses) from the sale of a principal residence.

  • Gain can generally only be excluded from the sale of one residence every two years, and the taxpayer generally must have (in aggregate) owned and used the residence for two or more years during a five-year period.

  • Taxpayers that sell a principal residence less than two years after excluding gain from another sale of a principal residence may qualify for a partial exclusion of gain if the sale is due to a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.

    On May 6, 1997, Congress ended the once-in-a-lifetime, over-age-55 exclusion for the sale of a primary personal residence. In its place, Congress installed the current every-two-year, $500,000/$250,000 exclusion, which allows for multiple gain exclusions during a taxpayer’s lifetime. It is unclear whether the purpose of this law change was to recognize the more mobile lifestyle that our society had developed since the old Sec. 121 was passed in 1964 or to provide a tax break for homeowners who were experiencing significant appreciation in their primary residence. Regardless of the motivation, the exclusion provides a means for homeowners to frequently take the appreciation out of their principal residences with little or no federal income tax impact. To the average homeowner, it is probably the most widely known of the nontaxable tax attributes available.

    One condition for qualifying for the gain exclusion is that the taxpayer must use the property as his or her principal residence for a period of at least two years during a five-year period prior to the sale.1 Congress recognized that the two-year rule could cause an unintended hardship and therefore provided a partial waiver if the reason for the change in housing is due to (1) a change in place of employment, (2) a change in health, or (3) other unforeseen circumstances.2 The waiver does not permit the full use of the $500,000/$250,000 exclusion but only a prorated portion of the exclusion.

    In order to explore the planning opportunities available under the partial exclusion rule, it is first necessary to appreciate the basic rules of Sec. 121 and how to compute the partial exclusion exemption. The article then addresses the three justifications for applying the partial exclusion rule, including a discussion of each basic justification and the safe harbor for each. The article concludes with observations about the current IRS examples and how they appear to be more flexible than what the partial exclusion regulations seem to state.

    Basic Requirements for Sec. 121 Exclusion

    In order to comply with the Sec. 121 exclusionary provisions, a taxpayer must be attentive to four basic requirements.

    Principal Residence

    The residence being sold must be the taxpayer’s principal residence.3 If the taxpayer has multiple places of abode throughout the year, only one residence can be the principal residence—the property used the most during the year is ordinarily treated as the principal residence. The regulations under Sec. 121 make it clear that a variety of structures can qualify as a residence and that determining what is a “residence” is a facts-and-circumstances-dependent test.4 Factors such as mailing address, voter registration, place of employment, social clubs, and other affiliations affect the determination of a primary residence.

    One Sale Every Two Years

    Only one sale every two years may be covered by Sec. 121.5 There are limited exceptions to this requirement. Absent satisfaction of any one of these exceptions, the gain will be fully taxable. If the primary residence does not qualify for one of the exceptions from the two-year holding period but was held for more than one year, it will most likely qualify as a long-term capital asset with the resulting lower capital gain tax rates of 15%/5%;6 otherwise the taxpayer could be looking at a gain taxed at ordinary income tax rates.

    Owner/Use Test

    Ownership and use periods must in the aggregate equal two or more years during a five-year period.7 The ownership/use test is often the most difficult requirement to address because it involves not only issues of time measurement but of how the residence was acquired.8 While ownership and use are discussed concurrently here, as in the regulations, it is clear that they are two separate tests applied within the same five-year period. It is not necessary that ownership and occupancy of the home occur at the same time, only that they each occur within the same five-year period.9 Accordingly, it is entirely possible for a taxpayer to be a nonowner renter of a home for two years, to subsequently purchase the property in, say, the third year, and to move to a different house and sell the original home in the fourth year. Any gain from the sale in the fourth year would be subject to exclusion under Sec. 121.

    $500,000/$250,000 Exclusion Qualification

    Married filing jointly status normally permits taxpayers to obtain the $500,000 exclusion, while all other filing statuses receive a $250,000 exclusion.10 Single taxpayers, and even married taxpayers filing separately, may qualify for the $250,000 exclusion. The exclusion is not an annual exclusion but a per principal residence exclusion and, when coupled with the two-year limitation, can be used only once every two years by a taxpayer.11 After December 31, 2007, certain surviving spouses may qualify for the maximum $500,000 exclusion instead of the $250,000 exclusion if the residence is sold within two years of the spouse’s death.12

    Calculating the Partial Exclusion

    For those taxpayers selling a principal residence before the tolling of the two-year clock and qualifying for one of the many exceptions to the two-year rule, a partial exclusion is available.13 While two methods are provided for calculating the partial exclusion, a form of proration of the maximum exclusion is used.14 First, the taxpayer has to determine the eligibility as if the two-year rule has been fully satisfied. Second, the taxpayer must determine if the property qualifies for the $250,000 or the $500,000 exclusion. This maximum exclusion is multiplied by one of two alternative proration formulas shown in Exhibit 1.

    As with other instances in the Code, when options are provided to taxpayers, one option is normally distinctly better than the other. This may be true with the month and day methods of allocating the exclusion amount.

    Example: S and P, a married couple, meet all other Sec. 121 requirements but lived in their residence only from January 1, 2006, until April 15, 2007, at which time S was transferred from Sarasota, FL, to Fort Wayne, IN. S and P gained $400,000 on the sale of their Sarasota home in 2007. Using the months fraction, the gain excluded will be $312,500 (15 ÷ 24 × 500,000) and they will have a taxable gain of $87,500. Using the days fraction, the gain excluded will be $321,918 [(365 + 31 + 28 + 31 + 15) ÷ 730 × 500,000] and they will have a taxable gain of only $78,082.

    When property is bought and sold on other than the first or last day of a month, the days fraction should be more beneficial. In the unusual situation of beginning and end of the month transactions, the months fraction will normally be most beneficial. The regulation states that the measure of time in each fraction (both numerator and denominator) must be either days or whole months.15

    Qualification for Partial Exclusion

    When Congress revised Sec. 121 in 1997, it anticipated a problem with the two-year requirement’s being too rigid. Accordingly, it provided taxpayers with exceptions in the areas of employment, health, and unforeseen circumstances to cover situations that Congress could not reasonably anticipate when crafting the legislation.

    The problem of dealing with the partial exclusion is that there are no cases, revenue rulings, or revenue procedures to provide guidance to taxpayers on the delicate issues of compliance with the statutory mandates. Guidance can be found in regulations, letter rulings, and one notice.16 Before addressing these areas, an understanding of the regulation’s definitions, examples, and safe harbors is necessary. The following methodology is used in examining the current state of the law:

    • The regulation provides a definition of factors to be considered in assessing acceptable noncompliance with the two-year requirement.
    • Definitions are provided for employment, health, and unforeseen circumstances, and safe harbors are provided for each type, including examples.
    • The regulation and letter rulings provide examples outside the safe-harbor arena, discussing whether each qualifies for the partial exclusion.

    Partial Exclusion Factors: Definitions and Safe Harbors

    Regs. Sec. 1.121-3(b) provides guidance as to what is necessary to qualify for the employment, health, or unforeseen circumstances partial exclusions. These include such factors as whether events arose during the period of use and ownership, whether there was a material change in family needs, whether the family became financially impaired, and whether the circumstances causing the sale were reasonably foreseeable when the taxpayer began using the property. Each specific potential exclusion area is discussed below. These policy statements make clear that a facts-and-circumstances test is applied to each event to determine if the fact situation warrants the partial exclusion.

    Employment, health, and unforeseen circumstances each provide taxpayers with safe harbors to claim the partial maximum exclusion with the confidence of qualification. The health safe harbor is the least specific of the three areas.


    The employment qualification is often referred to as the “moving qualification” because of its similarity to the Sec. 217 moving expense deduction. As a defining factor, it asks whether the primary reason for the sale or exchange is a change of the taxpayer’s employment.17 It is not necessary to differentiate whether the employment is initial or continuing or whether the taxpayer is self-employed or an employee. The safe harbor narrows the requirements, making them more like the moving deduction requirements:

    • The change in place of employment must occur during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence; and
    • The qualified individual’s new place of employment must be at least 50 miles farther from the residence sold or exchanged than was the former place of employment, or, 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.

    Exhibit 2 summarizes the two safe-harbor examples from Regs. Sec. 1.121-3(c)(4). The safe-harbor test is mechanical: Did the change occur during ownership and use and is the 50-mile test satisfied? That is not to say that failure to satisfy the safe-harbor mechanical test means that the taxpayer cannot use the moving partial exclusion.

    Exhibit 3 summarizes the only two other fact situations dealing with moving (both qualifying facts-and-circumstances examples fall outside the safe-harbor rules). In the London example, the taxpayer fails the safe-harbor test but the regulation qualifies him for the partial exclusion. The IRS recognizes that the taxpayer must move to London to keep his job. The only reason the taxpayer did not sell his residence during the time of use and ownership was that the assignment away from home was initially believed to be temporary and the taxpayer would be returning to his home in Philadelphia. Apparently the test to be applied is “but for” the reassignment to London, the taxpayer would not have had to sell the home. However, the “but for” test was not explicitly articulated by the Service.

    In the ER doctor example, an emergency room (ER) physician voluntarily changes jobs, resulting in a drive to the new ER that is 46 miles farther than the old job site. Although this doctor works a schedule, she “may be called in to work unscheduled hours and . . . must arrive quickly.” No evidence is given for the unscheduled events ever occurring. Clearly, an employee moving at the employer’s request and under a compulsion to keep his or her employment seems well justified and within the regulation’s intent. The ER example, however, provides no similar justification for this move. In the real world, only the smallest of rural hospitals have just one ER physician on duty at a time; with normal staffing, nonrural hospitals will have multiple ER physicians plus hospital staff physicians available to work in an emergency situation. The example does not state that no other doctors are available. This would diminish the need for the ER doctor to have to move just because she elected to change jobs. In both the London and ER examples, the Service, outside the safe-harbor rule, seems to be offering taxpayers a degree of reasonable latitude.


    The second area of qualification for a partial exclusion is health. If health is the reason for the sale or exchange, it must involve a disease, illness, or injury of a qualified individual, or the sale must be made in order to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. The regulation makes it clear that it requires more than merely being beneficial to one’s general health or well-being.18 The regulation provides a safe-harbor definition of health19 by stating that a physician’s recommended change in residence is deemed to qualify. The definition of a physician is the same as the definition used in determining qualified itemized medical deductions.20

    The same problem present in itemized deductions for health care travel is present in the Sec. 121 health partial exclusion: At what point is the physician’s order for the patient’s direct physical or mental health and not for the patient’s general well-being? In Exhibit 2, the asthma and backswing examples from the regulations bracket the issue of medical need with the same results that one would expect if the question were one of the deductibility of medical travel costs. As with medical itemized deductions, it is clear that just because a physician “orders” the move for health reasons, that will not in itself be sufficient. The physician’s order will be given much weight, but the condition’s qualification as health related is important, with or without the physician’s order.

    The regulation makes it clear that the reason for the change of residence must be primarily health motivated. A sale or exchange of a residence merely to benefit one’s general health or well-being will not in itself qualify. In order for the sale to qualify as health related, the taxpayer must be selling or exchanging the residence to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease, illness, or injury or to obtain or provide medical or personal care for a disease, illness, or injury of a qualified individual. 21

    Each of the remaining regulation examples summarized in Exhibit 3 fits within the definition of health, and none of them incorporates any form of physician authorization. One letter ruling22 deals with a non-safe-harbor fact situation of bringing an ill relative into the family home and requiring more space to meet that person’s medical needs. The Service considered this an acceptable health reason for the move. None of the examples or the letter ruling provide any broad policy guidance on the definition of health or its safe harbor.

    Unforeseen Circumstances

    Unforeseen circumstances is the most difficult of the three areas under which to qualify for a partial exclusion because the Service’s guidance is the least precise. “Unforeseen circumstance” is defined as “an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.”23 Preferences for a different home or an improved financial condition enabling the taxpayer to buy a better home are specifically excluded from qualifying events. Even with this narrowing of the definition, unforeseen circumstances are still quite broad and fact dependent. The safe harbor provides specific examples as to what qualifies:24

    1. Death;
    2. The cessation of employment as a result of which the taxpayer is eligible for unemployment compensation;
    3. A change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household (including amounts for food, clothing, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary to the production of income but not for the maintenance of an affluent or luxurious standard of living);
    4. Divorce or legal separation under a decree of divorce or separate maintenance;
    5. Multiple births resulting from the same pregnancy;
    6. Natural or manmade disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under Sec. 165(h));
    7. Involuntary conversion of the residence.

    Exhibit 2 summarizes the only three examples from the regulations of events that qualify under the unforeseen circumstances safe harbor. In each example, a very narrow fact situation, not a broad policy, is demonstrated: earthquake, loss of employment by one wage earner in a two-wage-earner household, or the birth of twins to a couple currently living in a two-bedroom home. No guidance has been provided about the safe harbor of economic distress or how proximate a disaster or terrorism event must be to the taxpayer.25

    Exhibit 3 provides a summary of all regulation examples and letter rulings dealing with unforeseen circumstances outside the safe-harbor guidance. Three regulation examples, seven letter rulings, and one notice provide factual support for unforeseen circumstances. None of these, however, provides any broad policy guidance that taxpayers and advisers can rely on in alternative fact situations. These 11 fact situations fall into six categories:

    Terror 1
    Financial distress 1
    Matrimony 1
    New job duties


    Hostile neighbors 3
    Birth 3

    Flexibility of the Partial Exclusion Exemption

    It is clear that if a fact situation falls within an employment, health, or unforeseen circumstances safe-harbor definition and safe-harbor examples, the application of the partial exclusion is appropriate. It is more interesting that these fact situations appear to fall wholly outside the safe harbors. They expand the definitions because the IRS has ruled that they qualify for the partial exclusion. Many of the regulations, letter rulings, and notice examples in Exhibit 3 seem to be consistent with the spirit and definition of partial exclusion. For example:

    Moving to London: The taxpayer’s decision to move to London was in response to the employer’s request even though the taxpayer was not living in the residence at the time of the move.

    Dependent’s needs: Without a doctor’s order, the taxpayers moved to be closer to a health care facility that could provide medical treatment for their son, a qualified individual.

    Violent neighborhood II: The taxpayer was a victim of a violent crime originating in his neighborhood, causing such stress that the taxpayer could not continue to live there.

    The following examples do not appear to fit quite as clearly within the regulation definitions because the fact situations are subject to alternative interpretations. To the extent that reasonable alternative assessments are appropriate, tax advisers and taxpayers can consider the additional flexibility the IRS is providing.

    ER doctor: The vast majority of ER doctors work established schedules and are not on call, so it makes no difference how far they live from the hospital. However, since the Service believes the potential of being called to work and ease of arrival are important, tax advisers can use this justification for a partial exclusion.26

    Condominium fee increase: The IRS states that the condominium fee increased by 100% in one year after purchase, creating an unforeseen financial hardship. The facts do not disclose whether the taxpayer performed due diligence at the time of purchase to determine the condominium association’s current and near-term financial condition. A reasonable person would have performed due diligence and might have discovered a pending 100% fee increase. The definition of unforeseen circumstances is “unforeseeable at the time of purchase.” Home ownership costs will increase and are foreseeable. The letter ruling, however, concentrates on only one component of home ownership costs without mention of debt service, insurance, and real estate taxes, which may be more significant than the condominium fee. The Service seems to ask whether the 100% increase in one cost was foreseen by the taxpayer, not whether the increases in the overall cost of ownership were foreseeable. By emphasizing a small component of the total cost of maintaining a primary residence, the ruling seems to give tax advisers justification in markets where certain ownership costs are volatile.27

    Engagement gone sour: In this regulation example, an engaged couple purchased a primary residence. When the engagement failed, the IRS allowed a partial exclusion because neither person could afford the house individually. The concept of unforeseeability has always been applied on a reasonable-person standard. There is little question that this specific couple did not foresee their engagement terminating and the house having to be sold. However, the appropriate question should have been whether a “reasonable person” couple in their position could have foreseen the possibility or probability of the engagement ending before marriage. That answer should have been yes and the Service’s answer to the example should have been contrary. Either this example expands the unforeseen circumstances safe harbor of divorce to include pre-marital breakups and continues the use of “foreseen by the taxpayer” rather than “foreseeable,” or it creates a separate allowable fact situation.28

    Taking in child/grandchild: It is not uncommon for parents to let a child and a grandchild move into their home after the child’s marriage ends. The IRS allowed the taxpayers a partial exclusion because they moved out of an age-limited community. No reference was made to the duration of the child’s stay—the implication is that the daughter and the grandchild will stay with the taxpayers for some extended or indefinite period. Does a three-week, three-month, or two-year stay with the parents qualify for the partial exclusion? It appears that tax advisers do not need to know or to affirm the duration.29

    Adoption of another child: While the decision to adopt a child has many merits, the issue in this letter ruling is unforeseeability. If the future can be predicted, then it is foreseeable. At the time the taxpayers purchased the principal residence, they apparently had no intent to adopt a child and did not need the additional space. The taxpayers, however, changed their minds and decided to adopt. In this example, the adoption is a voluntary decision by the taxpayers and arguably is therefore not an “unforeseeable event.”30

    Death threats: Due to a vice police officer’s involvement in a high-profile drug arrest, the officer felt the need to move to a different home because the drug dealer knew where he lived and threatened the lives of the officer and his family. The IRS agreed that the partial exclusion applied. The events affecting the officer appear to clearly fall within unforeseeable circumstances because there was no way the officer could anticipate or provide for the adverse consequences of his drug case assignment. However, it is difficult to understand the justification for the move. The letter ruling implies that the police officer moved so the local criminal element would not know where he lived. It is difficult to believe that the criminal element would not know the new address before the officer actually moved in. Even with the difficulty of appreciating how just moving would lower the officer’s visibility, it seems that the IRS considered the taxpayer’s meritorious service in assessing the applicability of the partial exclusion.31


    The partial exclusion of gains on the sale of a primary residence continues to be an attractive benefit for taxpayers. Congress rightly foresaw a dilemma in trying to narrowly define those instances in which application of the partial exclusion is appropriate beyond the general criteria of health, employment, and unforeseen circumstances. With the only official guidance coming from the IRS in the form of Regs. Sec. 1.121-3, a series of letter rulings, and a notice,32 substantial policy guidance is lacking. This lack of specific policy guidance from the Service or any developing case law leaves tax advisers and taxpayers with reasonable latitude.

    The safe harbors for health, employment, and unforeseen circumstances provide identifiable havens. Beyond the safe harbors, the positions articulated by the IRS in both the regulation examples and the letter rulings appear to reflect a posture asking (1) if the taxpayer acted as a reasonable person and (2) in some instances if that taxpayer’s action was reasonable.

    The difficulty for the tax adviser is that many of the examples in this area come from letter rulings having limited authoritative application. However, the letter rulings do bolster the tax adviser’s understanding of how the IRS will apply the partial exclusion and the safe harbors. Until the law becomes more developed, tax advisers can use these examples (along with the examples in the regulations and other guidance) to counsel taxpayers about the application of the partial exclusion in their particular situations.

    For more information about this article, contact Prof. Cockrum at or Prof. Cabán-García at


    1 Sec. 121(a).

    2 Sec. 121(c)(2).

    3 Regs. Sec. 1.121-1(b).

    4 See Regs. Sec. 1.121-1(b)(1). A residence can be a house, condominium, houseboat, house trailer, mobile home, and the unit a tenant-shareholder is entitled to occupy in a housing cooperative.

    5 Sec. 121(b)(3).

    6 Sec. 1(h).

    7 Regs. Sec. 1.121-1(c).

    8 Discussion of the impact of Sec. 1031 like-kind exchanges and Sec. 1033 involuntary conversions is beyond the scope of this article. For an in-depth discussion, see Orbach and Dilley, “Sale of a Residence and Like-Kind Exchanges,” 36 The Tax Adviser 678 and 746 (November and December 2005).

    9 Regs. Sec. 1.121-1(c)(1).

    10 Sec. 121(b).

    11 Sec. 121(b)(3).

    12 Sec. 121(b)(4), added by the Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142. To qualify, the couple must have met the provisions of Sec. 121(b)(2)(A) for a joint return immediately before the death of the spouse, and the surviving spouse must be unmarried and must sell the residence within two years after the spouse’s death.

    13 Sec. 121(c).

    14 See Regs. Sec. 1.121-3(g)(1).

    15 Id.

    16 See Letter Rulings 200403049 (9/26/03), 200601009 (9/30/05), 200601022 (9/30/05), 200601023 (9/30/05), 200613009 (12/19/05), 200615011 (12/8/05), 200630004 (4/28/06), and 200626024 (7/28/06), and Notice 2002-60, 2002-2 CB 482.

    17 See Regs. Sec. 1.121-3(c)(1).

    18 Regs. Sec. 1.121-3(d)(1).

    19 See Regs. Sec. 1.121-3(d)(2).

    20 See Sec. 213(d)(4) for the definition of “physician.”

    21 See. Regs. Sec. 1.121-3(f), which defines a qualified individual as the taxpayer and the taxpayer’s spouse, a co-owner of the residence, any person whose principal place of abode is in the same household as the taxpayer, and others.

    22 See Letter Ruling 200626024 (7/28/06).

    23 Regs. Sec. 1.121-3(e)(1).

    24 Regs. Sec. 1.121-3(e)(2).

    25 However, in Notice 2002-60, 2002-2 CB 482, the IRS announced that taxpayers affected by the 9/11 terrorist attack may qualify for the partial exclusion if a qualified taxpayer was killed, the taxpayer’s principal residence was damaged, a qualified individual lost his or her job and became eligible for unemployment, or a qualified individual experienced a change in employment or self-employment that resulted in the taxpayer’s inability to pay reasonable basic living expenses for his or her household.

    26 Regs. Sec. 1.121-3(c)(4), Example 4.

    27 Regs. Sec. 1.121-3(e)(4), Example 4.

    28 Regs. Sec. 1.121-3(e)(4), Example 6.

    29 Letter Ruling 200601023 (9/30/05).

    30 Letter Ruling 200613009 (12/19/05).

    31 Letter Ruling 200615011 (12/8/05).

    32 Note 16 above.


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