In the recently released Private Letter Ruling 201628002, the IRS determined that taxpayers were entitled to partial gain exclusion for the sale of their principal residence. Despite not using the property as their principal residence for at least 2 years, the taxpayers were entitled to a partial exclusion because the move was precipitated by unforeseen circumstances; namely, the birth of a second child in the taxpayers' family.

The taxpayers were a married couple with one child. On Date 1, the taxpayers purchased residence 1, a condominium with two bedrooms and two baths (the "Property"). Subsequently, the taxpayer-wife gave birth to another child.  Accordingly, on Date 2, the taxpayers moved out of the Property and into a new principal residence. On Date 3, the taxpayers sold the Property. The taxpayers questioned whether the sale of the Property was eligible for the gain exclusion as a sale of their principal residence.

A married couple filing a joint return can exclude from income up to $500,000 of gain attributable to the sale of their principal residence.  I.R.C. § 121(a), (b)(2). To qualify for the gain exclusion, for at least two of the prior five years, the taxpayer must have (a) owned the property and (b) used the property as his or her principal residence.  If, however, the taxpayer's primary reason for the sale is the occurrence of unforeseen circumstances, the taxpayer may be eligible for partial gain exclusion.  I.R.C. § 121(c). In determining whether the taxpayer sold the property primarily due to unforeseen circumstances, the IRS looks at:  (1) whether the subject property continued to be suitable for use as the taxpayer's principal residence; (2) whether the impetus for the sale was not reasonably foreseeable when the taxpayer acquired the property; and (3) whether the impetus for the sale occurred while the taxpayer was using the property as his or her principal residence. If the taxpayer qualifies for the reduced exclusion, the amount of the exclusion is determined using by multiplying the maximum exclusion (here, $500,000) by a fraction intended to capture the amount of time during the prior two years that the taxpayer used or owned the property.

The IRS determined that the birth of the second child was an unforeseen circumstance.  Further, the primary reason for the sale of the Property was the taxpayers' need for a larger principal residence, necessitated by the unforeseen circumstances. The Property was no longer suitable for the taxpayers' residential needs. Accordingly, the IRS concluded that the taxpayers were entitled to partial gain exclusion on their sale of the Property.

Taxpayers should be aware of this ruling, which offers a generous interpretation of the "unforeseen circumstances" exception to the requirements for exclusion of gain on a residential sale.  

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