After years of uncertainty, the IRS has now delivered the answers to questions that have bedeviled home sellers, Realtors® and professional tax advisers. The IRS clarified its rules on capital gains exclusions for profits on home sales.
The largest category of people affected are those who sell their homes prior to the standard two-year holding period required for the maximum capital gains exclusions of $250,000 (single filers) and $500,000 (married, joint filers). The standard rules allow sellers to exclude up to those maximum amounts of sale profits provided they have owned and used their property as a principal residence for an aggregate two out of the five years preceding the sale. Any profits beyond the exclusion amounts are taxed at capital gains rates.
For taxpayers who sell after ownership and use of less than two years, Congress created a partial exclusion or shelter back in 1997-1998: You can claim a portion of the maximum exclusion if you sell early because of a change in employment, a change in health, or because of “unforeseen circumstances.” For example, a single homeowner who sold his property for a profit after just one year because of a corporate transfer could claim one-half of the full $250,000 standard exclusion = $125,000.
In the absence of formal regulatory guidance from the IRS interpreting employment change, health change and “unforeseen circumstances”, many taxpayers have been reluctant to use the partial exclusion. The IRS itself warned taxpayers not to claim “unforeseen circumstances” on their returns until the agency itself spelled out precisely what circumstances qualify.
Now the IRS has done so with interim rules, opening the door to partial exclusion claims for tax year 2002 and any prior year’s returns where a refund may be available under the new rules. (For such situations, taxpayers can file for refunds using Form 1040X.)
On “unforeseen circumstances,” the IRS lists seven major categories that create a “safe harbor” that automatically makes the claim eligible:

Death of the taxpayer, a spouse, a co-owner or any member of the taxpayer’s household.
Divorce or legal separation. o A job loss that results in eligibility for unemployment compensation.
A change in employment that leaves the taxpayer unable to pay the mortgage or basic living expenses.
Multiple births from the same pregnancy.
Damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism.
Condemnation, seizure or other involuntary conversion of the property.

The regulations also give the IRS commissioner the discretion to determine other circumstances that qualify as unforeseen
On employment changes that trigger early sales, the IRS rule is straightforward: “A home sale will be considered related to a change in employment if a qualified person’s new place of work is at least 50 miles farther from the old home than the old workplace was from that home. This is the same distance rule that applies for the moving expense deduction. The employment change must occur during the taxpayer’s ownership and use of the home as a residence.
The new rules allow a partial exclusion for health if “the primary reason is related to a disease, illness or injury” of the home seller or member of the household. If a physician recommends a change in residence for health reasons, that will be sufficient to claim the exclusion.
Home Sale Capital Gains Exclusion Limitations Involving A Principle Residence Acquired Through A 1031 Exchange:
On October 22, 2004, new tax legislation became effective that places a five-year restriction on 1031 exchanges involving a principle residence. A taxpayer who exchanges into a rental property as a replacement property that is later converted into their primary residence, is not allowed to exclude capital gain under the principal residence exclusion rules, unless the sale occurs at least five years from the date of its acquisition. Any taxpayer, who previously acquired their current residence through a tax-deferred exchange within the past three years, will now have to wait at least another two years before selling their home and excluding any capital gain. This assumes the taxpayer meets the two out of five year occupancy test.
Before taking any steps towards a transaction involving possible capital gains tax exclusions, please consult your CPA, attorney or tax advisor.