[Federal Register Volume 67, Number 247 (Tuesday, December 24, 2002)]
[Rules and Regulations]
[Pages 78367-78371]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32280]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9031]
RIN 1545-BB02


Reduced Maximum Exclusion of Gain From Sale or Exchange of 
Principal Residence

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains temporary regulations relating to the 
exclusion of gain from the sale or exchange of a taxpayer's principal 
residence in the case of a taxpayer who has not owned and used the 
property as the taxpayer's principal residence for two of the preceding 
five years or who has excluded gain from the sale or exchange of a 
principal residence within the preceding two years. The text of these 
temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking on this 
subject in the Proposed Rules section in this issue of the Federal 
Register.

DATES: Effective Date: These regulations are effective December 24, 
2002.
    Applicability Date: For dates of applicability, see Sec.  1.121-
3T(l).

FOR FURTHER INFORMATION CONTACT: Sara Paige Shepherd, (202) 622-4960 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under section 121(c) relating to the exclusion of gain from 
the sale or exchange of the principal residence of a taxpayer who has 
not owned and used the property as the taxpayer's principal residence 
for two of the preceding five years or who has excluded gain on the 
sale or exchange of a principal residence within the preceding two 
years.
    Under section 121(a), a taxpayer may exclude up to $250,000 
($500,000 for certain joint returns) of gain realized on the sale or 
exchange of the taxpayer's principal residence if the taxpayer owned 
and used the property as the taxpayer's principal residence for at 
least two years during the five-year period ending on the date of the 
sale or exchange. Section 121(b)(3) allows the taxpayer to apply the 
maximum exclusion to only one sale or exchange during the two-year 
period ending on the date of the sale or exchange. Section

[[Page 78368]]

121(c) provides that a taxpayer who fails to meet any of these 
conditions by reason of a change in place of employment, health, or, to 
the extent provided in regulations, unforeseen circumstances, may be 
entitled to an exclusion in a reduced maximum amount.
    On October 10, 2000, a notice of proposed rulemaking (REG-105235-
99) under section 121 was published in the Federal Register (65 FR 
60136). The proposed regulations did not define change in place of 
employment, health, or unforeseen circumstances for purposes of the 
reduced maximum exclusion. Comments were specifically requested 
regarding what circumstances should qualify as unforeseen. A public 
hearing was held on January 26, 2001.
    The IRS and Treasury Department received numerous comments 
regarding the reduced maximum exclusion and have concluded that many of 
these comments should be adopted. However, because the rules formulated 
in response to these comments are extensive, the IRS and Treasury 
Department have concluded that the rules relating to the reduced 
maximum exclusion should be issued as proposed and temporary 
regulations to provide the public with adequate notice and opportunity 
to comment. Final regulations under section 121 addressing provisions 
other than the reduced maximum exclusion are set forth elsewhere in 
this edition of the Federal Register.

Explanation of Provisions

1. General Provisions

    Under the temporary regulations, a reduced maximum exclusion 
limitation is available to a taxpayer who has sold or exchanged 
property owned and used as the taxpayer's principal residence for less 
than two of the preceding five years or who has excluded gain on the 
sale or exchange of a principal residence within the preceding two 
years. This reduced maximum exclusion applies only if the sale or 
exchange is by reason of a change in place of employment, health, or 
unforeseen circumstances. A sale or exchange is by reason of a change 
in place of employment, health, or unforeseen circumstances only if the 
taxpayer's primary reason for the sale or exchange is a change in place 
of employment, health, or unforeseen circumstances. The taxpayer's 
primary reason for the sale or exchange is determined based on the 
facts and circumstances. The temporary regulations provide a list of 
factors that may be relevant in determining the taxpayer's primary 
reason. These factors are suggestive only. No single fact or particular 
combination of facts is determinative of the taxpayer's entitlement to 
the reduced maximum exclusion.
    In addition, for each of the three grounds for claiming a reduced 
maximum exclusion, the temporary regulations provide a general 
definition and one or more safe harbors. If a safe harbor applies, the 
taxpayer's primary reason for the sale or exchange is deemed to be a 
change in place of employment, health, or unforeseen circumstances.

2. Change in Place of Employment

    The temporary regulations provide that a sale or exchange is by 
reason of a change in place of employment if the taxpayer's primary 
reason for the sale or exchange is a change in the location of the 
employment of a qualified individual. Employment is defined as the 
commencement of employment with a new employer, the continuation of 
employment with the same employer, or the commencement or continuation 
of self-employment. A qualified individual is defined as the taxpayer, 
the taxpayer's spouse, a co-owner of the residence, or a person whose 
principal place of abode is in the same household as the taxpayer.
    The temporary regulations adopt a safe harbor, suggested by 
commentators, that provides that the primary reason for the sale or 
exchange is deemed to be a change in place of employment if the new 
place of employment of a qualified individual is at least fifty miles 
farther from the residence sold or exchanged than was the former place 
of employment. If the individual was unemployed, the distance between 
the new place of employment and the residence sold or exchanged must be 
at least fifty miles. This standard is derived from section 217(c)(1) 
relating to the moving expense deduction. The safe harbor applies only 
if the change in place of employment occurs during the period of the 
taxpayer's ownership and use of the property as the taxpayer's 
principal residence. If a sale or exchange does not satisfy this safe 
harbor, a taxpayer may still qualify for the reduced maximum exclusion 
by reason of a change in place of employment if the facts and 
circumstances indicate that a change in place of employment is the 
primary reason for the sale or exchange.

3. Sale or Exchange by Reason of Health

    Commentators proposed that, for purposes of determining whether a 
sale or exchange is by reason of health, the regulations adopt 
standards similar to those for the deductibility of medical expenses 
under section 213(a). Commentators also suggested that the regulations 
provide that the reduced maximum exclusion by reason of health apply to 
sales and exchanges due to (1) advanced age-related infirmities, (2) 
the taxpayer's need to move in order to care for a family member, (3) 
severe allergies, and (4) emotional problems.
    In response to these comments, the temporary regulations provide 
the general rule that a sale or exchange is by reason of health if the 
taxpayer's primary reason for the sale or exchange is (1) to obtain, 
provide, or facilitate the diagnosis, cure, mitigation, or treatment of 
disease, illness, or injury of a qualified individual, or (2) to obtain 
or provide medical or personal care for a qualified individual 
suffering from a disease, illness, or injury. A sale or exchange that 
is merely beneficial to the general health or well-being of the 
individual is not a sale or exchange by reason of health.
    One commentator suggested that the regulations establish a safe 
harbor allowing a taxpayer to claim a reduced maximum exclusion if the 
taxpayer obtains documentation of a specific medical condition from a 
licensed physician. The temporary regulations provide a safe harbor 
that the primary reason for the sale or exchange is deemed to be health 
if a physician (as defined in section 213(d)(4)) recommends a change of 
residence for reasons of health.
    For purposes of the reduced maximum exclusion by reason of health, 
the term qualified individual includes the taxpayer, the taxpayer's 
spouse, a co-owner of the residence, a person whose principal place of 
abode is in the same household as the taxpayer, and certain family 
members of these individuals. The definition of qualified individual in 
the case of health is broader than the definition that applies to the 
exclusions by reason of change in place of employment and unforeseen 
circumstances to encompass taxpayers who sell or exchange their 
residence in order to care for sick family members.

4. Sale or Exchange by Reason of Unforeseen Circumstances

    The temporary regulations provide that a sale or exchange is by 
reason of unforeseen circumstances if the primary reason for the sale 
or exchange is the occurrence of an event that the taxpayer does not 
anticipate before purchasing and occupying the residence.
    Many commentators provided suggestions regarding circumstances that 
should qualify as unforeseen. A large number of commentators

[[Page 78369]]

suggested that unforeseen circumstances should encompass divorce or the 
termination of a permanent residential relationship. Others suggested 
that unforeseen circumstances should include death, birth, marriage, 
bankruptcy, the loss of employment, incarceration, admission to an 
institution of higher learning, natural and man-made disasters, 
involuntary conversions, and a substantial increase in medical or 
living expenses leading to a significant change in economic 
circumstances. One commentator suggested that any delay of over three 
years in selling the residence due to a decline in the real estate 
market should be deemed an unforeseen circumstance. A few commentators 
suggested that unforeseen circumstances should include unfavorable 
changes affecting the desirability of the property, such as 
environmental problems, zoning-law changes, slovenly neighbors, and 
serious nuisance or safety concerns.
    The temporary regulations adopt many of these suggestions as safe 
harbors. A taxpayer's primary reason for the sale or exchange is deemed 
to be unforeseen circumstances if one of the safe harbor events occurs 
during the taxpayer's ownership and use of the property. The safe 
harbor events include the involuntary conversion of the residence, a 
natural or man-made disaster or act of war or terrorism resulting in a 
casualty to the residence, and, in the case of a qualified individual: 
(1) Death, (2) the cessation of employment as a result of which the 
individual is eligible for unemployment compensation, (3) a 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, (4) divorce or legal separation under a 
decree of divorce or separate maintenance, and (5) multiple births 
resulting from the same pregnancy. The Commissioner may designate other 
events or situations as unforeseen circumstances in published guidance 
of general applicability or in a ruling directed to a specific 
taxpayer. A taxpayer who does not qualify for a safe harbor may 
demonstrate that the primary reason for the sale or exchange is 
unforeseen circumstances, under a facts and circumstances test.
    For purposes of the reduced maximum exclusion by reason of 
unforeseen circumstances, a qualified individual includes the taxpayer, 
the taxpayer's spouse, a co-owner of the residence, and a person whose 
principal place of abode is in the same household as the taxpayer.
    The regulations include examples illustrating the application of 
the safe harbors and the facts and circumstances test.

5. Election To Apply Regulations Retroactively

    The regulations provide that taxpayers who would otherwise qualify 
under these temporary regulations to exclude gain from a sale or 
exchange that occurred before the effective date of the regulations but 
on or after May 7, 1997, may elect to apply all of the provisions of 
the temporary regulations to the sale or exchange. A taxpayer may make 
the election by filing a return for the taxable year of the sale or 
exchange that does not include the gain from the sale or exchange of 
the taxpayer's principal residence in the taxpayer's gross income. 
Taxpayers who have filed a return for the taxable year of the sale or 
exchange may elect to apply all of the provisions of these regulations 
for any years for which the period of limitations under section 6511 
has not expired by filing an amended return.

6. Audit Protection

    The temporary regulations provide that the IRS will not challenge a 
taxpayer's position that a sale or exchange before the effective date 
of these regulations but on or after May 7, 1997, qualifies for the 
reduced maximum exclusion under section 121(c) if the taxpayer has made 
a reasonable, good faith effort to comply with the requirements of 
section 121(c) and if the sale or exchange otherwise qualifies under 
section 121.

7. Effective Date

    These temporary regulations apply to sales and exchanges on or 
after December 24, 2003.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
refer to the Special Analyses section of the preamble to the cross-
reference notice of proposed rulemaking published in the Proposed Rules 
section in this issue of the Federal Register. Pursuant to section 
7805(f) of the Internal Revenue Code, these temporary regulations will 
be submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Sara Paige Shepherd, 
Office of Associate Chief Counsel (Income Tax and Accounting). However, 
other personnel from the IRS and the Treasury Department participated 
in the development of the regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.121-3T is added to read as follows:


Sec.  1.121-3T  Reduced maximum exclusion for taxpayers failing to meet 
certain requirements (temporary).

    (a) [Reserved] For further guidance, see Sec.  1.121-3(a).
    (b) Primary reason for sale or exchange. In order for a taxpayer to 
claim a reduced maximum exclusion under section 121(c), the sale or 
exchange must be by reason of a change in place of employment, health, 
or unforeseen circumstances. A sale or exchange is by reason of a 
change in place of employment, health, or unforeseen circumstances only 
if the primary reason for the sale or exchange is a change in place of 
employment (within the meaning of paragraph (c) of this section), 
health (within the meaning of paragraph (d) of this section), or 
unforeseen circumstances (within the meaning of paragraph (e) of this 
section). Whether the requirements of this section are satisfied 
depends upon all the facts and circumstances. If the taxpayer qualifies 
for a safe harbor described in this section, the taxpayer's primary 
reason is deemed to be a change in place of employment, health, or 
unforeseen circumstances. If the taxpayer does not qualify for a safe 
harbor, factors that may be relevant in determining the taxpayer's 
primary reason for the sale or exchange include (but are not limited 
to) the extent to which--
    (1) The sale or exchange and the circumstances giving rise to the 
sale or exchange are proximate in time;

[[Page 78370]]

    (2) The suitability of the property as the taxpayer's principal 
residence materially changes;
    (3) The taxpayer's financial ability to maintain the property 
materially changes;
    (4) The taxpayer uses the property as the taxpayer's residence 
during the period of the taxpayer's ownership of the property;
    (5) The circumstances giving rise to the sale or exchange are not 
reasonably foreseeable when the taxpayer begins using the property as 
the taxpayer's principal residence; and
    (6) The circumstances giving rise to the sale or exchange occur 
during the period of the taxpayer's ownership and use of the property 
as the taxpayer's principal residence.
    (c) Sale or exchange by reason of a change in place of employment--
(1) In general. A sale or exchange is by reason of a change in place of 
employment if, in the case of a qualified individual described in 
paragraph (f) of this section, the primary reason for the sale or 
exchange is a change in the location of the individual's employment.
    (2) Distance safe harbor. The primary reason for the sale or 
exchange is deemed to be a change in place of employment (within the 
meaning of paragraph (c)(1) of this section) if--
    (i) The change in place of employment occurs during the period of 
the taxpayer's ownership and use of the property as the taxpayer's 
principal residence; and
    (ii) The individual's new place of employment is at least 50 miles 
farther from the residence sold or exchanged than was the former place 
of employment, or, if there was no former place of employment, the 
distance between the individual's new place of employment and the 
residence sold or exchanged is at least 50 miles.
    (3) Employment. For purposes of this paragraph (c), employment 
includes the commencement of employment with a new employer, the 
continuation of employment with the same employer, and the commencement 
or continuation of self-employment.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c):

    Example 1. A is unemployed and owns a townhouse that she has 
owned and used as her principal residence since 2002. In 2003 A 
obtains a job that is 54 miles from her townhouse, and she sells the 
townhouse. Because the distance between A's new place of employment 
and the townhouse is at least 50 miles, the sale is within the safe 
harbor of paragraph (c)(2) of this section and A is entitled to 
claim a reduced maximum exclusion under section 121(c)(2).
    Example 2. B is an officer in the United States Air Force 
stationed in Florida. B purchases a house in Florida in 2001. In May 
2002 B moves out of his house to take a 3-year assignment in 
Germany. B sells his house in January 2003. Because B's new place of 
employment in Germany is at least 50 miles farther from the 
residence sold than is B's former place of employment in Florida, 
the sale is within the safe harbor of paragraph (c)(2) of this 
section and B is entitled to claim a reduced maximum exclusion under 
section 121(c)(2).
    Example 3. C is employed by Employer R at R's Philadelphia 
office. C purchases a house in February 2001 that is 35 miles from 
R's Philadelphia office. In May 2002 C begins a temporary assignment 
at R's Wilmington office that is 72 miles from C's house, and moves 
out of the house. In June 2004 C is assigned to work in R's London 
office, and as a result, sells her house in August 2004. The sale of 
the house is not within the safe harbor of paragraph (c)(2) of this 
section by reason of the change in place of employment from 
Philadelphia to Wilmington because the Wilmington office is not 50 
miles farther from C's house than is the Philadelphia office. 
Furthermore, the sale is not within the safe harbor by reason of the 
change in place of employment to London because C is not using the 
house as her principal residence when she moves to London. However, 
C is entitled to claim a reduced maximum exclusion under section 
121(c)(2) because, under the facts and circumstances, the primary 
reason for the sale is the change in C's place of employment.
    Example 4. In July 2002 D buys a condominium that is 5 miles 
from her place of employment and uses it as her principal residence. 
In February 2003 D, who works as an emergency medicine physician, 
obtains a job that is located 51 miles from D's condominium. D may 
be called in to work unscheduled hours and, when called, must be 
able to arrive at work quickly. Therefore, D sells her condominium 
and buys a townhouse that is 4 miles from her new place of 
employment. Because D's new place of employment is only 46 miles 
farther from the condominium than is D's former place of employment, 
the sale is not within the safe harbor of paragraph (c)(2) of this 
section. However, D is entitled to claim a reduced maximum exclusion 
under section 121(c)(2) because, under the facts and circumstances, 
the primary reason for the sale is the change in D's place of 
employment.

    (d) Sale or exchange by reason of health--(1) In general. A sale or 
exchange is by reason of health if the primary reason for the sale or 
exchange is to obtain, provide, or facilitate the diagnosis, cure, 
mitigation, or treatment of disease, illness, or injury of a qualified 
individual described in paragraph (f) of this section, or to obtain or 
provide medical or personal care for a qualified individual suffering 
from a disease, illness, or injury. A sale or exchange that is merely 
beneficial to the general health or well-being of the individual is not 
a sale or exchange by reason of health.
    (2) Physician's recommendation safe harbor. The primary reason for 
the sale or exchange is deemed to be health if a physician (as defined 
in section 213(d)(4)) recommends a change of residence for reasons of 
health (as defined in paragraph (d)(1) of this section).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (d):

    Example 1. In 2002 A buys a house that she uses as her principal 
residence. A is injured in an accident and is unable to care for 
herself. As a result, A sells her house in 2003 and moves in with 
her daughter so that the daughter can provide the care that A 
requires as a result of her injury. Because, under the facts and 
circumstances, the primary reason for the sale of A's house is A's 
health, A is entitled to claim a reduced maximum exclusion under 
section 121(c)(2).
    Example 2. H's father has a chronic disease. In 2002 H and W 
purchase a house that they use as their principal residence. In 2003 
H and W sell their house in order to move into the house of H's 
father so that they can provide the care he requires as a result of 
his disease. Because, under the facts and circumstances, the primary 
reason for the sale of their house is the health of H's father, H 
and W are entitled to claim a reduced maximum exclusion under 
section 121(c)(2).
    Example 3. H and W purchase a house in 2002 that they use as 
their principal residence. Their son suffers from a chronic illness 
that requires regular medical care. Later that year their doctor 
recommends that their son begin a new treatment that is available at 
a medical facility 100 miles away from their residence. In 2003 H 
and W sell their house to be closer to the medical facility. 
Because, under the facts and circumstances, the primary reason for 
the sale is to facilitate the treatment of their son's chronic 
illness, H and W are entitled to claim a reduced maximum exclusion 
under section 121(c)(2).
    Example 4. B, who has chronic asthma, purchases a house in 
Minnesota in 2002 that he uses as his principal residence. B's 
doctor tells B that moving to a warm, dry climate would mitigate B's 
asthma symptoms. In 2003 B sells his house and moves to Arizona to 
relieve his asthma symptoms. The sale is within the safe harbor of 
paragraph (d)(2) of this section and B is entitled to claim a 
reduced maximum exclusion under section 121(c)(2).
    Example 5. In 2002 H and W purchase a house in Michigan that 
they use as their principal residence. H's doctor tells H that he 
should get more exercise, but H is not suffering from any disease 
that can be treated or mitigated by exercise. In 2003 H and W sell 
their house and move to Florida so that H can increase his general 
level of exercise by playing golf year-round. Because the sale of 
the house is merely beneficial to H's general health, the sale of 
the house is not by reason of H's health. H and W are not entitled 
to claim a reduced maximum exclusion under section 121(c)(2).

    (e) Sale or exchange by reason of unforeseen circumstances--(1) In

[[Page 78371]]

general. A sale or exchange is by reason of unforeseen circumstances if 
the primary reason for the sale or exchange is the occurrence of an 
event that the taxpayer does not anticipate before purchasing and 
occupying the residence.
    (2) Specific event safe harbors. The primary reason for the sale or 
exchange is deemed to be unforeseen circumstances (within the meaning 
of paragraph (e)(1) of this section) if any of the events specified in 
paragraphs (e)(2)(i) through (iii) of this section occur during the 
period of the taxpayer's ownership and use of the residence as the 
taxpayer's principal residence--
    (i) The involuntary conversion of the residence;
    (ii) Natural or man-made disasters or acts of war or terrorism 
resulting in a casualty to the residence (without regard to 
deductibility under section 165(h));
    (iii) In the case of a qualified individual described in paragraph
    (f) of this section--
    (A) Death;
    (B) The cessation of employment as a result of which the individual 
is eligible for unemployment compensation (as defined in section 
85(b));
    (C) A 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 (including amounts for 
food, clothing, medical expenses, taxes, transportation, court-ordered 
payments, and expenses reasonably necessary to the production of 
income, but not for the maintenance of an affluent or luxurious 
standard of living);
    (D) Divorce or legal separation under a decree of divorce or 
separate maintenance; or
    (E) Multiple births resulting from the same pregnancy; or
    (iv) An event determined by the Commissioner to be an unforeseen 
circumstance to the extent provided in published guidance of general 
applicability or in a ruling directed to a specific taxpayer.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (e):

    Example 1. In 2003 A buys a house in California. After A begins 
to use the house as her principal residence, an earthquake causes 
damage to A's house. A sells the house in 2004. The sale is within 
the safe harbor of paragraph (e)(2)(ii) of this section and A is 
entitled to claim a reduced maximum exclusion under section 
121(c)(2).
    Example 2. H works as a teacher and W works as a pilot. In 2003 
H and W buy a house that they use as their principal residence. 
Later that year W is furloughed from her job for six months. H and W 
are unable to pay their mortgage during the period W is furloughed. 
H and W sell their house in 2004. The sale is within the safe harbor 
of paragraph (e)(2)(iii)(C) of this section and H and W are entitled 
to claim a reduced maximum exclusion under section 121(c)(2).
    Example 3. In 2003 H and W buy a two-bedroom condominium that 
they use as their principal residence. In 2004 W gives birth to 
twins and H and W sell their condominium and buy a four-bedroom 
house. The sale is within the safe harbor of paragraph 
(e)(2)(iii)(E) of this section, and H and W are entitled to claim a 
reduced maximum exclusion under section 121(c)(2).
    Example 4. B buys a condominium in 2003 and uses it as his 
principal residence. B's monthly condominium fee is $X. Three months 
after B moves into the condominium, the condominium association 
decides to replace the building's roof and heating system. Six 
months later, B's monthly condominium fee doubles. B sells the 
condominium in 2004 because B is unable to pay the new condominium 
fee along with the monthly mortgage payment. The safe harbors of 
paragraph (e)(2) of this section do not apply. However, under the 
facts and circumstances, the primary reason for the sale is 
unforeseen circumstances, and B is entitled to claim a reduced 
maximum exclusion under section 121(c)(2).
    Example 5. In 2003 C buys a house that he uses as his principal 
residence. The property is located on a heavily trafficked road. C 
sells the property in 2004 because the traffic is more disturbing 
than he expected. C is not entitled to claim a reduced maximum 
exclusion under section 121(c)(2) because the safe harbors of 
paragraph (e)(2) of this section do not apply and, under the facts 
and circumstances, the traffic is not an unforeseen circumstance.
    Example 6. In 2003 D and her fiance E buy a house and live in it 
as their principal residence. In 2004 D and E cancel their wedding 
plans and E moves out of the house. Because D cannot afford to make 
the monthly mortgage payments alone, D and E sell the house in 2004. 
The safe harbors of paragraph (e)(2) of this section do not apply. 
However, under the facts and circumstances, the primary reason for 
the sale is unforeseen circumstances, and D and E are each entitled 
to claim a reduced maximum exclusion under section 121(c)(2).

    (f) Qualified individual. For purposes of this section, qualified 
individual means--
    (1) The taxpayer;
    (2) The taxpayer's spouse;
    (3) A co-owner of the residence;
    (4) A person whose principal place of abode is in the same 
household as the taxpayer; or
    (5) For purposes of paragraph (d) of this section, a person bearing 
a relationship specified in sections 152(a)(1) through 152(a)(8) 
(without regard to qualification as a dependent) to a qualified 
individual described in paragraphs (f)(1) through (4) of this section, 
or a descendant of the taxpayer's grandparent.
    (g) [Reserved]. For further guidance, see Sec.  1.121-3(g).
    (h) Election to apply regulations retroactively. Taxpayers who 
would otherwise qualify under this section to exclude gain from a sale 
or exchange before December 24, 2002 but on or after May 7, 1997, may 
elect to apply all of the provisions of this section for any years for 
which the period of limitations under section 6511 has not expired. The 
taxpayer makes the election under this paragraph (h) by filing a return 
for the taxable year of the sale or exchange that does not include the 
gain from the sale or exchange of the taxpayer's principal residence in 
the taxpayer's gross income. Taxpayers who have filed a return for the 
taxable year of the sale or exchange may elect to apply all the 
provisions of this section for any years for which the period of 
limitations under section 6511 has not expired by filing an amended 
return.
    (i) through (j) [Reserved]. See Sec.  1.121-3(i) through (j).
    (k) Audit protection. The Internal Revenue Service will not 
challenge a taxpayer's position that a sale or exchange of a principal 
residence that occurred before December 24, 2002 but on or after May 7, 
1997, qualifies for the reduced maximum exclusion under section 121(c) 
if the taxpayer has made a reasonable, good faith effort to comply with 
the requirements of section 121(c) and if the sale or exchange 
otherwise qualifies under section 121.
    (l) Effective date. For the applicability of this section, see 
Sec.  1.121-3(l).

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 11, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 02-32280 Filed 12-23-02; 8:45 am]
BILLING CODE 4830-01-P