Here’s good news. IRS regulations allow you to claim a prorated (reduced) gain exclusion—a percentage of the $250,000 or $500,000 exclusion in select circumstances.
The prorated gain exclusion equals the full $250,000 or $500,000 figure (whichever would otherwise apply) multiplied by a fraction.
The numerator of this fraction 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 for this fraction 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 the 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. You’re a married joint-filer. You’ve owned and used a home as your principal residence for 11 months. Assuming you qualify under one of the conditions listed above, your prorated joint gain exclusion is $229,167 ($500,000 × 11/24). Hopefully that will be enough to avoid any federal income tax hit from the sale.
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
1. the taxpayer (that would be you),
2. the taxpayer’s spouse,
3. any co-owner of the home, or
4. any person whose principal residence is within the taxpayer’s household.
In addition, almost any close relative of a person listed above also counts as a qualified individual. And any descendent of the taxpayer’s grandparent (such as a first cousin) also counts as a qualified individual.
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.
A premature sale is automatically considered to be primarily for health reasons whenever a doctor recommends a change of residence for reasons of a qualified individual’s health (meaning to obtain, provide, or facilitate care, as explained above). If you fail the automatic qualification, your facts and circumstances must indicate that the premature sale was primarily for reasons of a qualified individual’s health.
You cannot claim a prorated gain exclusion for a premature sale that is merely beneficial to the general health or well-being of a qualified individual.
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 different 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
In conclusion, we recommend to talk with a tax pro if you would like to discuss principal residence gain exclusion rules for any home sale and, especially, a sale of your home that has recently been a rental property.
We specialize in helping clients clarify their taxes so they keep more of their money. Many small business owners who come to see us in Fort Worth, TX generally do not understand the tax law enough to explain it to a fifth grader.