Guidance on the Reduced Exclusion for the Sale of a Principal Residence

By Kevin E. Murphy

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SEPTEMBER 2006 - The Taxpayer Relief Act of 1997 (H.R. 2014) eliminated the deferral of gain on the sale or exchange of a principal residence and provided a new exclusionary provision for such gains in IRC section 121. (IRC section 1034, which provided the general framework for the tax treatment of gain recognized on the sale or exchange of a principal residence, was repealed effective August 6, 1997.) The basic provision of IRC section 121 allows the exclusion of up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale or exchange of a principal residence.

To exclude gain, the taxpayer must have owned and used the residence as a principal residence for two of the five years prior to the sale. The exclusion is determined on an individual basis. If one spouse does not qualify, the qualifying spouse may still claim the $250,000 exclusion.

The exclusion applies to only one sale every two years, also determined on an individual basis. One spouse’s use of the exclusion within the two-year period does not prevent an otherwise eligible spouse from claiming the $250,000 exclusion.

IRC section 121(c) allows taxpayers who do not meet the two-of-five-years ownership-and-use requirements due to a change in employment, health, or unforeseen circumstances to take a reduced, prorated exclusion. The maximum exclusion is equal to $250,000 ($500,000 if married and both spouses qualify for exclusion) multiplied by the fraction of the two-year period in which the ownership-and-use requirements were met. The numerator of the fraction is the lesser of the aggregate periods in which the ownership-and-use tests were met during the five-year period ending on the date of the sale, or the period after the date of the most recent sale to which the exclusion applied.

Example. On July 2, 1997, S bought a condominium for $100,000. On August 15, 2002, she sold it for $140,000 and used the proceeds to purchase a house for $155,000 on September 15, 2002. S was transferred to another state and sold the house on June 15, 2003, for $165,000.

S owned and used the condominium as a principal residence for more than two years and excludes the $40,000 gain on the sale. S does not meet the two-year ownership-and-use test on the house. Because the sale was due to a change in employment, a pro rata amount of the $250,000 exclusion is allowed. The numerator of the fraction she can exclude is the lesser of the nine months she owned and used the condominium as a principal residence or the 10 months from the date of the sale of the condominium to the sale of the house. Her maximum exclusion is therefore $93,750 [$250,000 x (9 / 24)], so S can exclude the entire $10,000 gain on the sale of the house.

Although it is clear that the sale in the example is due to a change in employment, other situations are not as clear-cut. Similarly, IRC section 121 does not explicitly state what constitutes a sale due to health or unforeseen circumstances. On December 26, 2002, Treasury Regulations section 1.121-3T was issued to provide guidance and to serve as a comment document on what constitutes a change in employment, health, or unforeseen circumstances for purposes of the reduced exclusion under IRC section 121. To provide some assurance to taxpayers in determining if they qualify for the exclusion, the regulation provides a safe harbor for each of the three changes under which the taxpayer’s primary reason for the sale is deemed to meet this requirement. Even when the safe harbor tests are not explicitly met, the regulation provides general factors relevant in determining the primary reason for the sale, which are generously applied in examples of the facts-and-circumstances test.

General Factors

Without elaboration, Treasury Regulations section 1.121-3T(b) lists six factors that may be relevant in determining the primary purpose of the sale. It also indicates that the facts-and-circumstances analysis is not limited to these factors. The six factors are as follows:

  • The sale or exchange, and the circumstances giving rise to the sale or exchange, are proximate in time;
  • The suitability of the property as the taxpayer’s principal residence materially changes;
  • The taxpayer’s financial ability to maintain the property materially changes;
  • The taxpayer uses the property as a residence during the period of the taxpayer’s ownership of the property;
  • The circumstances giving rise to the sale or exchange are not reasonably foreseeable when the taxpayer begins using the property as a principal residence; and
  • The circumstances giving rise to the sale or exchange occur during the period of the taxpayer’s ownership and use of the property as a principal residence.

No specific examples are given that explicitly apply the general factors. Some examples involve situations in which the safe harbor tests are not met; these examples apply the general factors to allow the reduced exclusion.

Safe Harbor Qualifications

Each safe harbor test applies to changes related to a qualifying individual. Treasury Regulations section 1.121-3T(f) defines a qualifying individual as—

(1) The taxpayer;
(2) The taxpayer’s spouse;
(3) A co-owner of the residence;
(4) A person whose principal place of abode is in the same household as the taxpayer; or
(5) For purposes of paragraph (d) of this section, a person bearing a relationship specified in sections 152(a)(1) through 152(a)(8) (without regard to qualification as a dependent) to a qualified individual described in paragraphs (f)(1) through (4) of this section, or a descendant of the taxpayer’s grandparent.

The last type of qualifying individual is only for purposes of a sale due to health. Qualifying individuals for a sale due to health include a son, daughter, grandchild, stepson, stepdaughter, brother, sister, stepbrother, stepsister, father, mother, grandfather, grandmother, stepfather, stepmother, nephew, niece, aunt, uncle, and certain in-laws.

Sale Due to a Change in Employment

Treasury Regulations section 1.121-3T(c)(1) requires a change in the location of a qualifying individual’s employment for the sale to qualify as being made by reason of a change in employment. The safe harbor requires that the change in place of employment occur during the period of ownership and use of the residence and that the new place of employment be at least 50 miles farther from the residence being sold than was the former place of employment. Treasury Regulations section 1.121-3T(c)(2)(i)-(ii) specifies that if there was no former place of employment, then the distance between the new place of employment and the residence being sold must be at least 50 miles. (The distance requirement is the same as the requirement for the deduction of moving expenses.) Treasury Regulations section 1.121-3T(c)(4) provides several useful examples, summarized below.

Example. A is unemployed and owns a townhouse that she has owned and used as her principal residence since 2002. In 2003, she obtains a job 54 miles from her townhouse, and sells the townhouse. Because the distance between A’s new place of employment and the townhouse is at least 50 miles, the sale is within the safe harbor, and she is entitled to claim a reduced maximum exclusion under section 121(c)(2).

When the distance test is not met, the regulation invokes the facts-and-circumstances test to allow the exclusion when there is a change in job location.

Example. In July 2002, D buys a condominium five miles from her place of employment. In February 2003, D takes a new job 51 miles from her condominium. Because D must be able to arrive at work quickly when called, she sells her condominium and buys a townhouse four miles from her new place of employment. Because this is only 46 miles farther away, the sale is not within the safe harbor. D is, however, entitled to claim a reduced maximum exclusion under section 121(c)(2) because, under the facts and circumstances, the primary reason for the sale is the change in her place of employment.

Sale Due to Health

Treasury Regulations section 1.121-3T(d)(1) allows a reduced exclusion if the sale is “to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury” or “to obtain or provide medical care or personal care for a disease, illness, or injury” of a qualified individual. Sales that are merely beneficial to the general health or well-being of a qualified individual do not qualify for the exclusion. The safe harbor under Treasury Regulations section 1.121-3T(d)(2) requires that the sale be the result of a physician’s recommendation. Treasury Regulations section 1.121-3T(d)(3) provides useful examples, summarized below.

Example. B’s doctor tells B that moving to a warm, dry climate would mitigate B’s asthma symptoms. In 2003, B sells the house he bought in 2002 and moves to a warmer climate. The sale is within the safe harbor, and B is entitled to claim a reduced maximum exclusion under section 121(c)(2).

As with changes in employment, sales outside of the physician’s recommendation safe harbor are allowed under the facts-and-circumstances test as long as they meet the diagnosis, cure, mitigation, or treatment criteria and are not for the general well-being of the individual.

Example. In 2003, H and W sell a house they had bought only a year earlier in order to move into the house of H’s father so they can provide the care he requires as a result of a chronic disease. Because, under the facts and circumstances, the primary reason for the sale is the health of H’s father, H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

Sale Due to Unforeseen Circumstances

Treasury Regulations section 1.121-3T(e)(1) defines an unforeseen circumstance as “the occurrence of an event that the taxpayer does not anticipate before purchasing and occupying the residence.” Section 1.121-3T(e)(2) provides safe harbors for any of the following events that occur during the period of ownership and use as a residence:

(i) The involuntary conversion of the
residence.
(ii) Natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence [without regard to deductibility under section 165(h)].
(iii) In the case of a qualified individual described in paragraph (f) of this section,

(A) Death;
(B) The cessation of employment, as a result of which the individual is eligible for unemployment compensation as defined in section 85(b);
(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 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);
(D) Divorce or legal separation under a decree of divorce or separate maintenance; or
(E) Multiple births resulting from the same pregnancy.

Under section 1.121-3T(e)(3), the IRS Commissioner may determine an event to be an unforeseen circumstance to the extent provided in published guidance of general applicability, or in a ruling directed to a specific taxpayer.

A sale due to an involuntary conversion as defined in IRC section 1033 qualifies for the reduced exclusion. The receipt of insurance proceeds qualifies as a sale for purposes of Treasury Regulations section 121. This allows taxpayers with “small” gains to use the exclusionary provisions of Treasury Regulations section 121 rather than the deferral provisions of IRC section 1033.

Example. On July 2, 1997, S bought a condominium for $100,000. On August 15, 2002, she sold it for $140,000 and used the proceeds to purchase a house for $155,000 on September 15, 2002. The house was destroyed by a tornado on June 15, 2003, and she received $165,000 in insurance proceeds.

S does not meet the two-year ownership-and-use test on the house destroyed by the tornado. Because the sale was due to an involuntary conversion, a pro rata amount of the $250,000 exclusion is allowed. The numerator of the fraction she can exclude is the lesser of the nine months she owned and used the condominium as a principal residence, or the 10 months from the sale of the condominium to the destruction of the house. Her maximum exclusion therefore is $93,750 [$250,000 x (9 / 24)], and she can exclude the entire $10,000 gain on the sale of the house. Note that S can take the exclusion even if she does not purchase another residence. However, under the involuntary conversion rules, S would have to purchase another house costing at least $165,000 to defer recognition of the gain on the sale. Any deferred gain would reduce the basis of the new residence.

If the gain on an involuntary conversion of a principal residence is greater than the reduced exclusion amount, the amount realized for purposes of IRC section 1033 is reduced by the amount of gain excluded under IRC section 121. Under Treasury Regulations section 1.121-4(d)(2), the period of ownership and use of a new principal residence acquired as a result of an involuntary conversion includes the time the taxpayer owned and used the converted property as a principal residence.

Example. Assume that in the previous example, S received $265,000 in insurance proceeds, resulting in a gain of $110,000 on the involuntary conversion. S can exclude $93,750 of the gain. If S purchases another residence, the amount realized for purposes of IRC section 1033 is $171,250 ($265,000 – $93,750). If S purchases a new residence costing at least $171,250, the remaining $16,250 ($110,000 – $93,750) of gain will be deferred under IRC section 1033. The new residence is considered to have been owned and used as a principal residence since September 15, 2002.

The second safe harbor allows for sales due to natural or man-made disasters or due to acts of war or terrorism that result in a casualty to the residence. Because natural or man-made disasters would qualify under the involuntary conversion safe harbor, it is presumed that what constitutes a casualty is different from the involuntary conversion casualty. The regulations provide no guidance regarding what constitutes a casualty for purposes of a natural or man-made disaster, or an act of war or terrorism, or an unforeseen circumstance. Notice 2002-60, IRB 2002-36, addressed the treatment of the reduced maximum exclusion for taxpayers affected by the September 11, 2001, terrorist attacks. According to the notice, an unforeseen circumstance qualifies if the taxpayer sells the residence as a result of being affected by the attack in one or more of the following ways:

  • A qualified individual (taxpayer, spouse, co-owner, or person whose principal place of abode is in the same household) was killed;
  • The taxpayer’s principal residence was damaged [even if no deduction is allowed under IRC section 165(h)];
  • A qualified individual lost employment and became eligible for unemployment insurance; 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 the taxpayer’s household (including amounts for food, clothing, housing and related expenses, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary to production of income, but not for the maintenance of an affluent or luxurious standard of living).

In Notice 2002-60, the IRS indicated that the final regulations on unforeseen circumstances should incorporate the notice’s guidelines. In fact, the language of the notice is incorporated into the language of the regulations’ third safe harbor, for death and cessation or change of employment. Applying the notice’s criteria to the regulation safe harbor, the natural or man-made disaster or act of war or terrorism does not have to result in damage to the residence to qualify as an unforeseen circumstance. The death of the taxpayer, the taxpayer’s spouse, a co-owner, or a person whose principal place of abode is in the same household, due to a natural or man-made disaster or act of war or terrorism, is sufficient to qualify for the safe harbor. Similarly, loss of employment by such individuals due to a natural or man-made disaster, or act of war or terrorism, that makes them eligible for unemployment compensation, or a change in employment/self-employment that renders the individual incapable of paying reasonable basic living expenses will also qualify as an unforeseen circumstance. The examples in Treasury Regulations section 1.121-3T(e)(3), summarized below, enforce this result:

Example. In 2003, H and W buy a house that they use as their principal residence. Later that year, W is furloughed from her job for six months and the couple is unable to pay their mortgage. H and W’s sale of the house in 2004 is within the safe harbor of Treasury regulations section 1.121-3T(e)(2)(iii)(C), and they are entitled to claim a reduced maximum exclusion under IRC section 121(c)(2).

As with the previous interpretations, the regulation takes a taxpayer-friendly approach to unforeseen circumstances that do not meet the safe harbor requirements. In an example in the regulations, the taxpayers sold a residence due to doubling of the monthly condominium fee and were entitled to claim a reduced maximum exclusion.

A sale due to a divorce or legal separation is an unforeseen circumstance. Taxpayers who divorce within two years after purchasing a residence can exclude gain realized on the sale if they have not met the two-year ownership-and-use test prior to the sale date.

Example. K and S married on June 1, 2001. They lived in K’s residence as joint tenants, which she had purchased and occupied on August 15, 1998, for $85,000. They divorced in 2003 and sold the residence for $390,000 on February 1, 2003.

K and S realized a $305,000 ($390,000 – $85,000) gain on the sale. K met the ownership-and-use test and excluded $250,000 of the gain. S had owned and occupied the residence for only 20 months and thus did not qualify for the safe harbor. But because the sale was due to divorce, it qualified as an unforeseen circumstance and S could exclude up to $208,333 [$250,000 x (20  24)] of gain on the sale under the reduced exclusion provision.

Retroactive Application

Treasury Regulations section 1.121-3T(h) allows retroactive application of the provisions for sales of a principal residence by reason of a change in employment, health, or unforeseen circumstances for sales before December 24, 2002, but on or after May 7, 1997. Taxpayers who have previously recognized gains on the sale of a principal residence may elect to apply the provisions for any years for which the statute of limitations has not expired by filing an amended return for that year. In addition, the IRS will not challenge that a sale within the eligible time period qualifies for the reduced exclusion if the taxpayer has made a good-faith effort to comply with the requirements of IRC section 121(c) and if the sale otherwise qualifies under IRC section 121.

Taxpayer-Friendly Guidance

The issuance of Treasury Regulations section 1.121-3T provides much-needed guidance for sales of principal residences in which the ownership-and-use tests are not met due to a change in employment, health, or unforeseen circumstances. The guidance is very taxpayer-friendly. The safe harbor tests provide certainty in applying the reduced exclusion for taxpayers falling within the safe harbors. In addition, the definition of a qualifying individual expands the scope of these events to many other individuals. In those instances in which a safe harbor test is not explicitly met, the regulation applies the facts-and-circumstances test in a reasonable manner. This approach enlarges the set of situations qualifying for the reduced exclusion. Taxpayers who have previously paid tax on a gain that qualifies for a reduced exclusion should file an amended return and claim a refund of tax paid on the portion of
the gain that qualifies for the reduced exclusion.


Kevin E. Murphy, PhD, is an associate professor of accounting at Oklahoma State University, Stillwater, Okla.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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