29.4 Reduced Maximum Exclusion

Generally, no exclusion is allowed on a sale of a principal residence if you owned or used the home for less than two of the five years preceding the sale (29.2). Similarly, an exclusion is generally disallowed if within the two-year period ending on the date of sale, you sold another home at a gain that was wholly or partially excluded from your income.

However, even if a sale of a principal residence is made before meeting the ownership and use tests or it is within two years of a prior sale for which an exclusion was claimed, an exclusion is available if the primary reason for the sale is: (1) a change in the place of employment, (2) health, or (3) unforeseen circumstances. If the sale is for one of these qualifying reasons, you are entitled to a prorated portion of the regular $250,000 or $500,000 exclusion limit. The employment change, health problem, or unforeseen circumstance can be attributable to you or another “qualified individual,” as defined below.

You automatically qualify for the reduced exclusion if your sale is within a safe harbor established by the IRS. If a safe harbor is not available, you may qualify by showing that the “facts and circumstances” of your situation establish that the primary reason for the sale was a change in the place of employment, health problem or unforeseen circumstances.

When you fall within a safe harbor or meet the primary reason test, you are allowed an allocable percentage of the regular $250,000 or $500,000 exclusion limit, depending on how much of the regular two-year ownership and use test was satisfied, or the time between this sale and a sale within the prior two years. For example, if you owned and lived in your home for 438 days before selling it to take a new job, you are entitled to 60% of the regular exclusion limit, which is based on 730 qualifying days (438/730 = 60%). Use Worksheet 29-1 to figure your reduced exclusion limit. Although the maximum exclusion is reduced, this may not disadvantage you. If the reduced exclusion limit equals or exceeds your gain, none of your gain is subject to tax.

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Amended Return to Claim Reduced Maximum Exclusion
If you reported gain on a sale that can be avoided under the reduced maximum exclusion rules for sales due to a change in place of employment, health, or unforeseen circumstances, a refund claim can be made on an amended return, provided the prior year is not closed by the statute of limitations (47.2).
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Qualified individual.

In addition to yourself, the following persons are considered qualified individuals for purposes of qualifying for the reduced maximum exclusion: your spouse, a co-owner of the residence, or any person whose main home was your principal residence.

For purposes of the “health reasons” category, qualified individuals include not only the above individuals but also their family members: parents or step-parents, grandparents, children, stepchildren, adopted children, grandchildren, siblings (including step- or half-siblings), in-laws (mother/father, brother/sister, son/daughter), uncles, aunts, nephews, or nieces.

EXAMPLE
You bought and moved into your residence on April 1, 2011. In 20112 you move to a new job location in another state and sell your house at a gain of $50,000 on March 31, 2012. Since you owned and used your home for 365 days, your exclusion limit is reduced by 50%. You are single. Your reduced exclusion limit is $125,000 (50% of $250,000) and since the gain of $50,000 is totally covered by the exclusion it is not taxable.

Sale due to change in place of employment.

The reduced exclusion limit applies if the primary reason for your sale is a change in the location of a qualified individual’s employment; see the above definition of qualified individual. “Employment” includes working for the same employer at a different location or starting with a new employer. It also includes the commencement of self-employment or the continuation of self-employment at a new location.

The IRS provides a safe harbor based on distance. If a qualified individual’s new place of employment is at least 50 miles farther from the sold home than the old place of employment was, the reduced exclusion limit is allowed so long as the change in employment occurred while you owned and used the home as your principal residence. If an unemployed qualified person obtains employment, the safe harbor applies if the sold home is at least 50 miles from the place of employment.

If the 50-mile safe harbor cannot be met, the facts and circumstances may indicate that a change in the place of employment was the primary reason for the sale, thereby allowing the reduced exclusion limit.

EXAMPLE
An emergency room physician buys a condominium in March 2011 that is five miles from the hospital where she works. In November 2012, she takes a new job at a hospital 51 miles away from her home. She sells her home in December 2012 and buys a townhouse that is four miles away from the new hospital. The sale does not qualify for the 50-mile safe harbor since the new hospital is only 46 miles further from the old home than the first hospital was. However, given the doctor’s need to work unscheduled hours and to get to work quickly, the IRS allows the reduced exclusion limit; the facts show that her change in place of employment was the primary reason for the home sale.

Sale due to health problems.

The reduced exclusion limit applies if a principal residence is sold primarily to obtain or facilitate the diagnosis, treatment, or mitigation of a qualified person’s disease, illness or injury, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. A sale does not qualify if it is merely to improve general health. Note that for “health sales,” the definition of qualified individual is broadened to include family members; see above.

A physician’s recommendation of a change in residence for health reasons automatically qualifies under an IRS safe harbor.

EXAMPLES
1. One year after purchasing a home in Michigan, Smith is told by his doctor that moving to a warm, dry climate would mitigate his chronic asthma symptoms. Smith takes the advice, selling the house and moving to Arizona. The sale is within the doctor recommendation safe harbor and Smith may claim a reduced maximum exclusion for gain on the sale of the Michigan home.
2. In 2012, Mike and Kathy Anderson sell the house they bought in 2011 so they can move in with Kathy’s father, who is chronically ill and unable to care for himself. The IRS allows the Andersons to claim a reduced maximum exclusion, as the primary reason for the sale is to provide care for Kathy’s father, a qualified individual.

Sale due to unforeseen circumstances.

A sale of a principal residence due to any of the following events fits within an IRS safe harbor for unforeseen circumstances and automatically qualifies for a reduced maximum exclusion:

(1) The involuntary conversion of the home;
(2) Damage to the residence from a natural or man-made disaster, war, or act of terrorism;
(3) Any of the following events involving a qualified individual (see above): death, divorce, or legal separation, becoming eligible for unemployment compensation, a change in employment or self-employment status that left the qualified individual unable to pay housing costs and reasonable basic household expenses, or multiple births resulting from the same pregnancy.

The IRS may expand the list of safe harbors in generally applicable revenue rulings or in private rulings requested by individual taxpayers.

Sales not covered by a safe harbor can qualify if the facts and circumstances indicate that the home was sold primarily because of an event that could not have been reasonably anticipated before the residence was purchased and occupied. The IRS in private letter rulings has been quite liberal in allowing the reduced maximum exclusion for unforeseen sales. However, an improvement in financial circumstances does not qualify under IRS regulations, even if the improvement is the result of unforeseen events, such as receiving a promotion and a large salary increase that would allow the purchase of a bigger home.

EXAMPLES
1. Three months after Jones buys a condominium as his principal residence, the condominium association replaces the roof and heating system and a few months later the monthly condominium fees are doubled. If Jones sells the condo because he cannot pay the higher fees and his monthly mortgage payment, the sale is considered to be due to unforeseen circumstances and Jones may claim a reduced maximum exclusion.
2. Tom and his fiancée, Alice, buy a house and live in it as their principal residence. The next year they break up and Tom moves out. The house is sold because Alice cannot afford to make the monthly payments alone. According to the IRS, the sale is due to unforeseen circumstances and Alice and Tom may each claim a reduced maximum exclusion.
3. A married couple purchased a home in a retirement community that had minimum age requirements for residents. Shortly after they moved in, their daughter lost her job and was in the process of getting a divorce. The daughter and her child wanted to move in but could not because of the community’s age requirements. The couple sold the home and bought a new one in which their daughter and grandchild lived while the daughter looked for full-time employment. The IRS privately ruled that the sale of the retirement community home was due to unforeseen circumstances and the reduced maximum exclusion could be claimed.
4. A single mother bought a home and lived in it with her two daughters as their principal residence. One of the daughters was subjected to unruly behavior, verbal abuse, and sexual assault on the school bus. As a result, the daughter suffered from persistent fear and her school performance seriously declined. Her behavior was noticed by the school and brought to the mother’s attention. She tried to work with the school district to resolve the problem, but when attempts failed, she sold her home and moved. The mother had not owned the home for two full years and asked the IRS whether she qualified for a partial exclusion. The IRS said yes. The primary reason for the sale prior to satisfying the two-year test was an unforeseen circumstance—the extreme bullying suffered by her daughter. Therefore, she can prorate the home sale exclusion for the part of the two years that she owned and lived in the home.

Worksheet 29-1 Reduced Maximum Exclusion

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