Neighbors’ Hostility Allowed Partial Gain Exclusion on Residence Sale.

The IRS offers guidance on “unforeseen circumstances.”

RC section 121(c) allows a partial exclusion of gain from the sale of a principal residence for taxpayers who fail to meet the ownership, use and frequency-of-sale tests to qualify for the maximum exclusion under section 121(b) ($250,000 if single; $500,000 if married filing jointly). The IRS recently offered guidance on qualifying for the reduced exclusion, of which CPAs should be aware.

Temporary regulations section 1.121-3T(b) states that, for a taxpayer to claim a reduced maximum exclusion under section 121(c), the sale or exchange of the taxpayer’s residence must be due to a change in place of employment or in health or due to unforeseen circumstances, which depend on the facts and circumstances. One key requirement to qualify for the “unforeseen circumstances” exception is that the circumstances which gave rise to the sale or exchange of the residence must not have been reasonably foreseeable when the taxpayer began using the property as a personal residence.

Under temporary regulations section 1.121-3T(e)(2)(iv), the IRS is authorized, from time to time, to provide guidance on “unforeseen circumstances.” It now has done so.

In letter ruling 200403049, the taxpayers, husband and wife, owned and resided in a home (House 1). While residing there, another family member, A, committed a crime; this criminal was placed on probation and required to spend one year at a rehabilitation facility. During this period the couple relocated to a different neighborhood, sold House 1 and purchased a replacement residence (House 2).

The ruling indicates the taxpayers did not expect A to live with them in House 2 permanently. However, during the second month of the couple’s residency, A lived there under a court-ordered house arrest and continuing rehabilitation counseling.

According to the ruling, the couple’s neighbors did not welcome the former jailbird. Rather, they purportedly made threats against A, interfered with A’s attempts to find employment and objected to the former criminal’s spending time in the yard outside the couple’s house. In addition, A’s probation officer was said to believe A would have a better chance of reducing the period of house arrest and probation if the couple sold the house and moved.

The ruling held the taxpayers’ primary reason for selling House 2 was an unforeseen circumstance—the neighbors’ hostility. Because of this, the couple could exclude part of the gain on sale. The ruling’s facts are not inconsistent with the fact patterns of the six examples in temporary regulations section 1.121-3T(e)(3), which illustrate circumstances that might be “unforeseen” and so qualify a taxpayer for the section 121(c) reduced maximum exclusion.

For more information, see the Tax Clinic, edited by Terence Kelly, in the May 2004 issue of The Tax Adviser .

—Lesli Laffie, editor
The Tax Adviser

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