7851 / Can the maximum exclusion be reduced for gain on the sale of a principal residence due to special circumstances?

According to the regulations, in order for a taxpayer to claim a reduced maximum exclusion under IRC Section 121, the reason for the sale or exchange must be a change in place of employment, health, or unforeseen circumstances. If a safe harbor applies ( see below), a sale or exchange is deemed to have been made for one of those reasons. However, if a safe harbor does not apply, a sale or exchange is deemed to have been made for one of those reasons only if the primary reason for the sale or exchange was a change in place of employment, health, or unforeseen circumstances. Whether the requirements are satisfied depends upon all the facts and circumstances.²

Factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange include (but are not limited to) the extent to which: (1) the sale or exchange and the circumstances giving rise to the sale or exchange are proximate in time; (2) the suitability of the property as the taxpayer’s principal residence materially changes; (3) the taxpayer’s financial ability to maintain the property is materially impaired; (4) the taxpayer uses the property as the taxpayer’s residence during the period of the taxpayer’s ownership of the property; (5) the circumstances giving rise to the sale or exchange are not reasonably foreseeable when the taxpayer begins using the property as the taxpayer’s principal residence; and (6) the circumstances giving rise to the sale or exchange occur during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence.³

Change in place of employment. According to the regulations, a sale or exchange is due to a change in place of employment if, in the case of a “qualified individual” (i.e., the taxpayer, the taxpayer’s spouse, a co-owner of the house, or a member of the taxpayer’s household), the primary reason for the sale or exchange is a change in the location of the individual’s employment.⁴ Under the distance safe harbor, a sale or exchange is deemed to be by reason of a change in place of employment if: (1) the change occurs during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence; and (2) 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 (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 is at least 50 miles).⁵

Health reasons. A sale or exchange is due to health reasons if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a “qualified individual” (described above), or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. A sale or exchange that is merely beneficial to the general health or well-being of the individual is not a sale by reason of health.⁶ Under the physician’s recommendation safe harbor, a sale or exchange is deemed to be by reason of health if a physician recommends a change of residence for reasons of health.⁷

Unforeseen circumstances. A sale or exchange is caused by unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not have reasonably anticipated before purchasing and occupying the residence. A sale or exchange that occurred because of unforeseen circumstances does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.⁸

Under the specific event safe harbor, a sale or exchange is deemed to occur because of unforeseen circumstances if any of the events listed below occur during the period of ownership and use of the residence as the taxpayer’s principal residence: (1) the involuntary conversion of the residence; (2) natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under IRC Section 165(h)); or, (3) in the case of a “qualified individual” described above (a) death, (b) the 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, (d) divorce or legal separation under a decree of divorce or separate maintenance, or (e) multiple births resulting from the same
pregnancy.⁹

In addition, the Commissioner may designate other events or situations as unforeseen circumstances in published guidance of general applicability, or in a ruling directed to a specific taxpayer.¹⁰