8675 / Are there circumstances in which a taxpayer can exclude the gain on the sale of a principal residence even though the taxpayer fails to meet the requirements otherwise required for exclusion treatment?

If a taxpayer fails to meet the ownership and use requirements, or sells multiple principal residences within the two-year period (see Q 8674), a portion of the exclusion (as discussed below) may still be available if the principal residence is sold for reasons that were primarily caused by a change in the taxpayer's place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.¹ In determining a taxpayer's primary reason for selling a principal residence, the following factors are considered:

(1)  Whether the sale and the circumstances giving rise to the sale are proximate in time;

For taxpayers claiming a Section 121 exclusion based on a change in place of employment, a safe harbor applies if the change in employment occurs during the period of the taxpayer's ownership and use of the property as a principal residence and the taxpayer's new place of employment is at least 50 miles from the residence that was sold.³

Similarly, for taxpayers claiming the exclusion based on health reasons, a safe harbor exists for taxpayers whose physician has recommended a change in residence for health reasons.⁴

The exception for a sale based on "unforeseen circumstances" may be met based on any of the following specific events:

(1)  An involuntary conversion of the residence;

The taxpayer does not qualify for the exclusion based on unforeseen circumstances if the unforeseen circumstance is an improvement in the taxpayer's financial condition.⁶

Example: In April 2025 George buys a house that he uses as his principal residence. He sells it in October 2026 because the house has greatly appreciated in value and mortgage rates have substantially decreased, making a bigger house affordable. The specific event safe harbors described above do not apply. In examining the facts and circumstances of the case, the primary reasons for the sale of the house—the changes in George's house value and in the mortgage rates—are an improvement in his financial circumstances. However, an improvement in financial circumstances, even if the result of unforeseen circumstances, does not qualify for the reduced maximum exclusion by reason of unforeseen circumstances under IRC Section 121(c)(2).⁷

For purposes of determining the reduced exclusion, the maximum amount of gain that would have been excluded but for the premature sale of the principal residence is multiplied by a fraction. The numerator of the fraction equals the shorter of (1) the aggregate periods during the five-year period ending on the date of the sale or exchange that the property has been owned or used by the taxpayer as a principal residence, or (2) the period between the date of the most recent prior sale or exchange by the taxpayer to which the two-year limitation applied and the date of the sale or exchange. The denominator equals two years.⁸

Example: On July 2, 2024, Ashley, a single taxpayer, purchased her first principal residence for $150,000. More than two years later, on August 15, 2026, Ashley sold the home for $200,000. Because she met all the requirements of IRC Section 121, Ashley excluded the entire amount of her gain. On September 15, 2026, Ashley purchased a new principal residence for $250,000. Nine months later, on June 15, 2027, Ashley sold the new principal residence for $275,000 because she lost her job and had to take a new job in a different state.

If the taxpayer is mentally or physically incapable of caring for himself, and the taxpayer owned and used the property as a principal residence for an aggregate of one year during the five-year period ending on the date of the sale or exchange, an exception to the use requirement applies. Such a taxpayer will be treated as using the property during any time within the five-year period that the taxpayer owns the property and resides in a facility (including a nursing home) licensed by the state or a political subdivision to care for such an individual.⁹