The original law is §121 of the Tax Code. One issue left open in 1997 was qualification for the "Reduced Exclusion." The Temporary Proposed Regs 1.121- 3T cover this.

To recap, the law requires that you:

1. USE the home as your Principal Residence for 2 of the 5 years before the sale of the home; and
2. OWN the home for 2 of the 5 years before the sale of the home.
3. Finally, you must wait 2 years before selling a home tax free again. (I.e. You have not sold a home tax free within the 2 years before this sale.)

However, if you do not meet all 3 of the 2 year rules you may qualify for the "Reduced Exclusion" (which I call the "Proportional Rule"). This allows the exclusion to be reduced proportionally, based on the how close you were to meeting the 2 year rule.

Let's assume that you sold your old home tax free (since you met the 3 tests on that old sale). It closed 1.8 years ago. Then you bought a new home 1.6 years ago; the seller rented back, and you moved in 1.4 years ago.

Now you sell the home. What is taxable? Did you meet the 3 tests? NO: you failed all of them.

1. Use Test: you used the property for only 70% of 2 years;
2. Ownership Test: you owned the property for 80% of 2 years;
3. Frequency Test: you sold the old home too recently; 90% of the 2 year requirement.

1. A change in health;
2. A change in employment location; OR
3. Other unforeseen circumstances to be defined by the IRS.

Until issuance of the 12/24/2002 Proposed Regulations, the IRS position was that there could be no unforeseen circumstances, because they were not yet defined. As an example, if the sale (after less than 2 years) in 2001 was caused by a divorce, although we felt it should qualify, IRS had not yet defined anything so IRS said it did NOT qualify.

Now we have some answers on which we may rely, by the Proposed Regulations. (Although they are "Proposed" and not "Final" Regulations, they state that now we may use these rules without fear that they will be altered retroactively.)

CHANGE IN PLACE OF EMPLOYMENT has been defined in several ways.

A) A move where the new commute would be at least 50 miles more than the old commute. If I had to drive 27 miles to work from my old home, and my new job is 65 miles from the old home, I do not meet the 50 mile longer rule. (If the commute from my old home to the new job location is 78 miles, I meet this test.)

[Many professionals expected this 50 mile rule (as it is the same for deductibility of moving expenses). IRS has adopted this as a "safe harbor" (which allows automatic qualification). If you qualify under this 50 mile test, you are safe.]

The IRS has elaborated further:

1. a move for an unemployed person to a job location at least 50 miles from his old home;
2. a job transfer;
3. a new job; and
4. new self-employment, also qualify.

B) IRS has also stated that failure to satisfy the 50 mile safe harbor is not fatal, if other circumstances make it clear that the primary reason for the sale of the old home is due to a change in job location.

NOTE WELL: Whose job location must change?
The taxpayer, his spouse, a co-owner of the home, or another resident of the home.

IRS examples include an emergency medical technician who is on-call and lives 4 miles from the hospital. She changes jobs to a hospital 40 miles away and sells her old home to live close to her new job. She fails the 50 mile test, but qualifies under the "other circumstances" test: she proved that move due to her job location change.

CHANGE IN HEALTH has been defined in several ways:

To obtain, provide, or facilitate diagnosis, cure, mitigation or treatment of a health condition, or personal care.

Moving to a new climate for specific health reasons (the allergist said that the cold damp climate aggravates my asthma; I should move to the dry desert) qualifies. However, a move to the desert for my general health (since I will be able to get more outdoor exercise which is good for my heart condition or general health) is NOT sufficient (since I do not have to move to exercise - I can exercise indoors at my old home).

NOTE WELL: Whose health do we look to?
The taxpayer, his spouse, a co-owner of the home, or another resident of the home, PLUS certain other close family members (or their spouses, co-owners, residents). This means that if I move so I can be close to my ill mother and help give her personal care, I QUALIFY.

UNFORESEEN CIRCUMSTANCES
IRS has given us a very nice provision. The following are safe harbors:

1. Death
2. Loss of job resulting in collecting unemployment
3. A change in employment (or self-employment) causing inability to pay housing and living expenses
4. Divorce or legal separation
5. Multiple births from the same pregnancy

OTHER UNFORESEEN CIRCUMSTANCES:
In addition, any other not reasonably foreseeable circumstance causing the property to be unsuitable as the principal residence, or making the residence unaffordable, now qualify.

IRS examples include a person who buys a home on a busy street, only to find it is too busy and noisy. This condition is foreseeable so it does NOT qualify.

A more favorable result is when Diane and Ed, an engaged but unmarried couple, buy a home. If they break up, and Ed moves out, this qualifies as an unforeseen circumstance entitling both to the Reduced Exclusion.

RETROACTIVITY
Although IRS had previously taken the position that until they issue the present Regulations, as such unforeseen circumstances had not yet been defined, they clearly apply retroactively.