Excluding part of the gain from the sale of a residence.

• Author: Ellentuck, Albert B.

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)).

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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))...