Exceptions to the 2 Year Lookback requirement
One of the conditions for taking the Section 121 Exclusion (exclusion of taxable gain up to $250,000 or $500,000 for married filing jointly) is the exclusion of taxable gain must not have been taken within the last 2 years. In addition the home must have been owned and used as a primary residence for 2 years.
Given the rapid rise in home prices it is not unlikely that your home could have appreciated quickly. Let’s say you are selling your home for a profit after living there for only 18 months instead of the required two years, so you fail the ownership and use tests. Or you might be selling your current home less than two years after excluding gain from the sale of a previous residence, so you can’t exclude taxable gain.
IRS regulations allow you to claim a prorated (reduced) gain exclusion—a percentage of the $250,000 or $500,000 exclusion that might otherwise be available in some circumstances.
The prorated gain exclusion equals the full $250,000 or $500,000 figure (whichever would otherwise apply) multiplied by a fraction. The numerator is the shorter of the aggregate period of time you owned and used the property as your principal residence during the five-year period ending on the sale date, or the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold. The denominator is two years, or the equivalent in months or days. When you qualify for the prorated exclusion, it might be big enough to shelter the entire gain from making a premature sale. But the prorated exclusion loophole is available only when your premature sale is due primarily to a change in place of employment, health reasons, or specified unforeseen circumstances.
Example 1. You’re a married joint-filer. You’ve owned and used a home as your principal residence for 11 months. Assuming you qualify, your prorated joint gain exclusion is $229,167 ($500,000 × 11/24). Hopefully that will be enough to avoid any federal income tax from the sale.
Example 2. You’re unmarried. You sold your previous home 15 months ago and excluded the gain. Now you’re about to sell your current home, which you’ve owned and used as your principal residence for 21 months. You bought the current home and occupied it for six months before selling the previous home. Assuming you qualify, your prorated gain exclusion is $156,250 ($250,000 × 15/24). Hopefully that will be enough to avoid any federal income tax from selling your current home.
Premature Sale Due to Employment Change
Per IRS regulations, you’re eligible for the prorated gain exclusion privilege whenever a premature home sale is primarily due to a change in place of employment for any qualified individual. Qualified individual means the taxpayer (that would be you), the taxpayer’s spouse, any co-owner of the home, or any other person whose main residence is within the taxpayer’s household. A premature sale is automatically considered to be primarily due to a change in place of employment if any qualified individual passes the following distance test: the distance between the new place of employment/self-employment and the former residence (the property that is being sold) is at least 50 miles more than the distance between the former place of employment/self-employment and the former residence.
Premature Sale Due to Health Reasons
Per IRS regulations, you are also eligible for the prorated gain exclusion privilege whenever a premature sale is primarily due to health reasons. You pass this test if your move is to
obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or obtain or provide medical or personal care for a qualified individual who suffers from a disease, an illness, or an injury.
Premature Sale Due to Other Unforeseen Circumstances
Per IRS regulations, a premature sale is generally considered to be due to unforeseen circumstances if the primary reason for the sale is the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.
But a premature sale that is primarily due to a preference for a difference residence or an improvement in financial circumstances will not be considered due to unforeseen circumstances, unless the safe-harbor rule applies. Under the safe-harbor rule, a premature sale is deemed to be due to unforeseen circumstances if any of the following events occur during your ownership and use of the property as your principal residence:
Involuntary conversion of the residence, a natural or man-made disaster or acts of war or terrorism resulting in a casualty to the residence, death of a qualified individual, a qualified individual’s cessation of employment, making him or her eligible for unemployment compensation, a qualified individual’s 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, a qualified individual’s divorce or legal separation under a decree of divorce or separate maintenance, multiple births resulting from a single pregnancy of a qualified individual.
