Excluding Part of the Gain From the Sale of a Residence

Editor: Albert B. Ellentuck, Esq.

A portion of the gain from the sale of a principal residence can be excluded when the taxpayer fails to meet the requirements for full exclusion of gain (i.e., the ownership and use requirements or the one-sale-in-two-years requirement) when the primary reason for selling or exchanging the principal residence was a change in place of employment, health, or unforeseen circumstances (Sec. 121(c); Regs. Sec. 1.121-3(b)).

As noted below, safe harbors are available for each of the three situations. If the taxpayer meets the safe harbor, the sale is deemed to be by reason of that event. However, taxpayers who do not meet a safe harbor can still qualify for a partial exclusion if they demonstrate that one of the three qualifying situations was the primary reason for the sale or exchange. The following may indicate that an event or circumstance was the primary reason for a premature home sale (Regs. Sec. 1.121-3(b)):

1. A short time between the sale and the circumstances giving rise to it;
2. The property’s suitability as the taxpayer’s principal residence materially changes;
3. The taxpayer’s financial ability to maintain the property is materially impaired;
4. The taxpayer used the property as a residence while he or she owned it;
5. The circumstances giving rise to the sale were not reasonably foreseeable when the taxpayer began using the property as the principal residence; and
6. The circumstances giving rise to the sale occurred while the taxpayer owned and used the home as a principal residence.

Observation: If taxpayers meet one of the safe harbors (described later), the safe-harbor event does not have to be the primary reason for the sale (although the primary purpose test must still be satisfied if a safe harbor is not met) (Regs. Sec. 1.121-3(b)).

The partial exclusion is based on a fraction, which is multiplied by the maximum allowable exclusion (i.e., $250,000 for a single filer or $500,000 for married filing jointly). The numerator of the fraction is the shorter of: (1) the period of time the taxpayer owned the property during the five-year period ending on the date of the sale or exchange; (2) the period of time that the taxpayer used the property as the taxpayer’s principal residence during the five-year period ending on the date of the sale or exchange; or (3) the period of time between the date of a prior sale or exchange of property for which the taxpayer excluded gain under Sec. 121 (Regs. Sec. 1.121-3(g)(1)). The numerator of the fraction can be expressed in days or months. The denominator of the fraction is 730 days or 24 months (i.e., two years), depending on the measure of time used in the numerator.

Example 1: S sells her residence on Sept. 1 and excludes $245,000 of gain. She buys a new house on the same date. On Dec. 1 of the same year, she moves to accept a promotion in a state 400 miles away. She sells the house on Oct. 1 of the following year for a $50,000 gain.

S can exclude part of the gain even though she did not own and occupy the house for two years and it has been less than two years since she used the exclusion. Because the move was due to a change in place of employment, S is allowed a partial exclusion. She owned the house for 395 days (i.e., 13 months), occupied it as a residence for 91 days, and at the time of sale it had been 395 days since she last used the exclusion. The shortest of the periods is 91 days, so she is entitled to an exclusion of up to $31,164 ((91 ÷ 730) × $250,000 maximum allowable exclusion). While S can exclude $31,164, the remainder of the gain would be taxed as long-term capital gain.

Change in Place of Employment

The change in place of employment test is met if the primary reason for the sale or exchange is a change in the location of the employment of a qualified individual (Regs. Sec. 1.121-3(c)(1)). A qualified individual is the taxpayer, the taxpayer’s spouse, a co-owner of the property, or a person whose principal place of abode is in the same household as the taxpayer (Regs. Sec. 1.121-3(f)).

Under a distance safe harbor, the primary reason for the sale or exchange is deemed to be a change in place of employment if (1) the change in place of employment occurs while the taxpayer owns and is using the property as a principal residence; and (2) the 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, or, if there was no former place of employment, the distance between the individual’s new place of employment and the residence sold or exchanged is at least 50 miles (Regs. Sec. 1.121-3(c)(2)). Employment includes commencing employment with a new employer, continuing with the same employer, and commencing or continuing self-employment.

Observation: The safe-harbor test uses the same mileage guidelines that apply when determining if moving expenses are deductible under Sec. 217.

Example 2: A buys a condo in February that is five miles from her place of employment and uses it as her principal residence. In December of that same year, A, who works as an emergency medicine physician, obtains a job that is located 51 miles from her condo. Because she may be called in to work unscheduled hours and, when called, must be able to arrive quickly, A sells her condo and buys a new one that is four miles from her new job. Because her new job is only 46 (51–5) miles farther from the old condo than her former job, the sale is not within the safe-harbor rule. However, A is still entitled to the partial gain exclusion for the sale since, under those facts and circumstances, the primary reason for the sale is the change in her place of employment.

Health Reasons

The health reason test is met if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease, illness, or injury to a qualified individual (Regs. Sec. 1.121-3(d)(1)). A qualified individual includes the taxpayer, the taxpayer’s spouse, a co-owner of the property, or a person whose principal place of abode is in the same household as the taxpayer, and any of the following family members of these individuals:

• Parent, grandparent, stepmother, stepfather;
• Child, grandchild, stepchild, adopted child, eligible foster child;
• Brother, sister, stepbrother, stepsister, half-brother, half-sister;
• Mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, or daughter-in-law; and
• Uncle, aunt, nephew, niece, or cousin.

A sale or exchange that is merely beneficial to the general health or well-being of the individual does not qualify. Under a safe-harbor rule, a change in residence recommended by a physician (as defined in Sec. 213(d)(4) for medical deduction purposes) qualifies as a health reason (Regs. Sec. 1.121-3(d)(2)).

Unforeseen Circumstances

An unforeseen circumstance is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence (Regs. Sec. 1.121-3(e)). Under a safe harbor, the primary reason is deemed to be unforeseen circumstances if any of the following events occur during the period the taxpayer owns and uses the property as a principal residence (Regs. Sec. 1.121-3(e)(2)):

1. The involuntary conversion of the property.
2. Natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under Sec. 165(h)).
3. Any of the following in the case of a qualified individual (as defined earlier for the change-of-employment test): (a) death; (b) cessation of employment as a result of which the individual is eligible for unemployment compensation; (c) 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 food, clothing, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary for the production of income, but not for the maintenance of a luxurious standard of living); (d) divorce or legal separation under a decree of divorce or separate maintenance; or (e) multiple births from the same pregnancy.

An event the IRS designates as an unforeseen circumstance in published guidance of general applicability or in a ruling directed to a specific taxpayer. However, taxpayers may rely on only those determinations made by the IRS in published guidance of general applicability, and a ruling directed to a specific taxpayer does not establish a safe harbor of general applicability for other taxpayers. Examples of events designated as unforeseen circumstances in rulings directed to specific taxpayers include:

1. A probation officer’s recommendation to move to avoid harassment from neighbors and to increase the taxpayer’s chances of reducing probation and house arrest (Letter Ruling 200403049).
2. Criminal activities in the neighborhood, including assault and threats to the taxpayer’s son (Letter Ruling 200601009).
3. The taxpayer’s move to the school district where her children attended school after taxpayer remarried and moved into the new spouse’s home (Letter Ruling 200601022).
4. A move to a new home where the taxpayer’s child and grandchild could also live, due to the child’s changed circumstances (divorce and unemployment) requiring her to move back into her parent’s home (Letter Ruling 200601023).
5. The need for a larger home to facilitate an adoption (Letter Ruling 200613009).
6. The need for a larger home to accommodate a blended family upon marriage (Letter Ruling 200725018).

Example 3: N buys a house that she uses as her principal residence. The property is located on a heavily trafficked road. N sells the house nine months later because the traffic is more disturbing than she expected. N is not entitled to a partial gain exclusion because none of the safe harbors apply, and the traffic is not an unforeseen circumstance because N could have reasonably anticipated the traffic problem when she bought the house.

Example 4: Assume instead that N purchased a house on a bystreet that was not well-traveled. However, two months after she purchased the home, road construction on a major nearby street detoured traffic through her neighborhood, causing excessive noise. N was not informed about the upcoming road construction when she purchased the house. The excessive traffic is an unforeseen circumstance because N had no reason to expect traffic conditions to change so quickly (see Regs. Sec. 1.121-3(e)(4), Example (5)).

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 14th edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, Timothy Fontenot, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).