[Federal Register Volume 67, Number 247 (Tuesday, December 24, 2002)]
[Rules and Regulations]
[Pages 78358-78367]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32281]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9030]
RIN 1545-AX28


Exclusion of Gain From Sale or Exchange of a Principal Residence

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
exclusion of gain from the sale or exchange of a taxpayer's principal 
residence. These regulations reflect changes to the law made by the 
Taxpayer Relief Act of 1997, as amended by the Internal Revenue Service 
Restructuring and Reform Act of 1998.

DATES: Effective Date: These regulations are effective December 24, 
2002.
    Applicability Date: For dates of applicability, see Sec. Sec.  
1.121-1(f), 1.121-2(c), 1.121-3(l), 1.121-4(l), and 1.1398-3(d).

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

SUPPLEMENTARY INFORMATION: 

Background

    On October 10, 2000, the IRS and the Treasury Department published 
in the Federal Register (65 FR 60136) a notice of proposed rulemaking 
(REG-105235-99) under section 121 of the Internal Revenue Code. 
Comments were specifically requested regarding what circumstances 
should qualify as unforeseen for purposes of the reduced maximum 
exclusion under section 121(c). Written and electronic comments 
responding to the notice of proposed rulemaking were received. A public 
hearing was held on January 26, 2001.
    After considering all of the comments, the proposed regulations are 
adopted as amended by this Treasury decision. Proposed and temporary 
regulations regarding the reduced maximum exclusion are also published 
in this issue of the Federal Register.
    On September 9, 2002, the IRS published Notice 2002-60 (2002-36 
I.R.B. 482), which provides that certain taxpayers affected by the 
September 11, 2001, terrorist attacks may claim a reduced maximum 
exclusion for a sale or exchange of the taxpayer's principal residence 
by reason of unforeseen circumstances.

Explanation and Summary of Comments

1. Exclusion of Gain From the Sale or Exchange of a Principal Residence

    Under section 121 and the proposed regulations, 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.
a. Principal Residence
    The proposed regulations provide that whether property is used by 
the taxpayer as the taxpayer's residence, and whether the property is 
used as the taxpayer's principal residence, depends upon all the facts 
and circumstances. The proposed regulations further provide that if a 
taxpayer alternates between two properties, the property that the 
taxpayer uses a majority of the time during the year will ordinarily be 
considered the taxpayer's principal residence.
    Commentators requested a bright line test or a list of factors to 
identify a property as the taxpayer's principal residence in the case 
of a taxpayer with multiple residences. Other commentators questioned 
whether the property that a taxpayer uses a majority of the time during 
the year should generally be considered the taxpayer's

[[Page 78359]]

principal residence, arguing that the determination of the taxpayer's 
principal residence should be judged on a day-by-day, rather than a 
year-by-year, basis.
    The final regulations continue to provide that the residence that 
the taxpayer uses a majority of the time during the year will 
ordinarily be considered the taxpayer's principal residence. However, 
this test is not dispositive. The final regulations also include a 
nonexclusive list of factors that are relevant in identifying a 
property as a taxpayer's principal residence.
b. Vacant Land
    Commentators requested clarification of the circumstances in which 
vacant land surrounding a residential structure would be treated as 
part of the residence for purposes of section 121. Several commentators 
maintained that a taxpayer who sells vacant land should be entitled to 
the section 121 exclusion if the taxpayer used the vacant land in 
conjunction with a dwelling unit as the taxpayer's principal residence 
for at least two years.
    Under section 1034 and former section 121, a sale of vacant land 
that did not include a dwelling unit did not qualify as a sale of the 
taxpayer's residence. See Rev. Rul. 56-420 (1956-2 C.B. 519); Rev. Rul. 
83-50 (1983-1 C.B. 41); O'Barr v. Commissioner, 44 T.C. 501 (1965); Roy 
v. Commissioner, T.C. Memo. 1995-23; Hale v. Commissioner, T.C. Memo. 
1982-527. However, if the sale of vacant land was one of a series of 
transactions that included the sale of the house, and the series of 
transactions all occurred during the replacement period provided by 
section 1034 (two years before or after the date of the taxpayer's 
purchase of a replacement residence), the sale of vacant land and the 
sale of the house were treated as one sale. See Bogley v. Commissioner, 
263 F.2d 746 (4th Cir. 1959); Rev. Rul. 76-541 (1976-2 C.B. 246).
    Consequently, the final regulations provide that section 121 
applies to the sale or exchange of vacant land that the taxpayer has 
owned and used as part of the taxpayer's principal residence if the 
sale or exchange of the dwelling unit occurs within two years before or 
after the sale or exchange of the vacant land. The vacant land must be 
adjacent to land containing the dwelling unit and the sale or exchange 
of the vacant land must otherwise satisfy the requirements of section 
121.
    For purposes of sections 121(b)(1) and (2) (regarding the maximum 
limitation amount of the section 121 exclusion), sales or exchanges of 
the dwelling unit and vacant land are treated as one sale or exchange. 
Therefore, only one maximum limitation amount of $250,000 ($500,000 for 
certain joint returns) applies to the combined sales or exchanges of 
the vacant land and dwelling unit. In applying the maximum limitation 
amount to sales or exchanges that occur in different taxable years, 
gain from the sale or exchange of the dwelling unit, up to the maximum 
limitation amount under section 121(b)(1) or (2), is excluded first, 
and each spouse is treated as excluding one-half of the gain from a 
sale or exchange to which section 121(b)(2)(A) and Sec.  1.121-
2(a)(3)(i)(relating to the limitation for certain joint returns) apply. 
Sales or exchanges of the dwelling unit and adjacent vacant land in 
separate transactions are disregarded in applying section 121(b)(3) 
(restricting the application of section 121 to only 1 sale or exchange 
every 2 years) to each other but are taken into account as a sale or 
exchange of a principal residence on the date of each transaction in 
applying section 121(b)(3) to that transaction and the sale or exchange 
of any other principal residence.

2. Use as a Principal Residence

a. Occupancy Requirement
    Numerous commentators asserted that the two-year use requirement of 
section 121 should not require actual occupancy. Instead, they argued 
for a facts and circumstances test similar to the test employed under 
section 1034. Under that test, a taxpayer's non-occupancy of a 
residence would count as use if the taxpayer did not intend to abandon 
the property as the taxpayer's principal residence. The final 
regulations do not adopt this suggestion because it is inconsistent 
with the statutory approach under section 121 of aggregating periods of 
use over a five-year period, and with the legislative history that 
provides that ``a taxpayer must have owned the residence and occupied 
it as a principal residence for at least two of the five years prior to 
the sale or exchange.'' See H.R. Rep. No. 148, 105th Cong., 1st Sess. 
348 (1997), 1997-4 (Vol. 1) C.B. 319, 670; S. Rep. No. 33, 105th Cong., 
1st Sess. 37 (1997), 1997-4 (Vol. 2) C.B. 1067, 1117; H.R. Conf. Rep. 
No. 220, 105th Cong., 1st Sess. 386 (1997), 1997-4 (Vol. 2) C.B. 1457, 
1856.
    Commentators proposed a special exception to the occupancy 
requirement for taxpayers who are absent from the home for an extended 
period of time due to employment but have not purchased a replacement 
residence. Other commentators suggested that members of the uniformed 
services and the United States Foreign Service should be accorded a 
special exception because they are often away from home for extended 
periods of time. A commentator also requested that the home daycare 
industry be exempted from the occupancy requirement because calculating 
the days of actual occupancy presents a particular difficulty for home 
daycare providers who often use the same space for residential and 
business purposes.
    The final regulations do not adopt these comments because there is 
no specific authority under section 121 to provide exceptions to the 
use requirement except in the cases of property of a deceased spouse 
(section 121(d)(2)), property of a former spouse (section 
121(d)(3)(B)), and out-of-residence care (section 121(d)(7)). Moreover, 
section 1034 contained a special rule for members of the Armed Forces, 
which Congress did not include in enacting section 121.
b. Short Temporary Absences
    Commentators requested that the regulations specify a maximum 
period of time that would constitute a short temporary absence from the 
residence and be considered use for purposes of satisfying the two-year 
use requirement. One commentator suggested that periods of up to five 
years away from home due to international employment assignments should 
be considered short temporary absences.
    Because the determination of whether an absence is short and 
temporary depends on the facts and circumstances, the final regulations 
do not adopt these suggestions.
c. Property Used in Part as a Principal Residence
    The proposed regulations provide that if a taxpayer satisfies the 
use requirement with respect to only a portion of the property sold or 
exchanged, section 121 will apply only to the gain allocable to that 
portion. Thus, if the residence was used partially for residential 
purposes and partially for business purposes (mixed-use property), only 
that part of the gain allocable to the residential portion is 
excludable under section 121.
    Under section 121(d)(6), the exclusion does not apply to so much of 
the gain from the sale of the property as does not exceed depreciation 
attributable to periods after May 6, 1997. Commentators suggested that 
the enactment of section 121(d)(6) illustrates legislative intent to 
eliminate the allocation requirement for mixed-

[[Page 78360]]

use property that existed under prior law.
    The IRS and Treasury Department have reconsidered the allocation 
rules of the proposed regulations. The final regulations provide that 
section 121 will not apply to the gain allocable to any portion of 
property sold or exchanged with respect to which a taxpayer does not 
satisfy the use requirement if the non-residential portion is separate 
from the dwelling unit. Additionally, if the depreciation for periods 
after May 6, 1997, attributable to the non-residential portion of the 
property exceeds the gain allocable to the non-residential portion of 
the property, the excess will not reduce the section 121 exclusion 
applicable to gain allocable to the residential portion of the 
property. No allocation of gain is required if both the residential and 
non-residential portions of the property are within the same dwelling 
unit, however, section 121 will not apply to the gain to the extent of 
any post-May 6, 1997, depreciation adjustments. The final regulations 
provide that the term dwelling unit has the same meaning as in section 
280A(f)(1), but does not include appurtenant structures or other 
property.
    A commentator asked for clarification regarding how to allocate the 
basis and the amount realized under the allocation rules between the 
portions of the property used for business and residential purposes. 
The commentator suggested that the regulations should require 
allocation on the same basis used to determine previous depreciation 
deductions. The regulations adopt this comment and provide that the 
taxpayer must use the same method to allocate the basis and the amount 
realized between the business and residential portions of the property 
as the taxpayer used to allocate the basis for purposes of 
depreciation, if applicable.

3. Ownership by Trusts

    Commentators suggested that the regulations adopt the holdings of 
Rev. Rul. 66-159 (1966-1 C.B. 162) and Rev. Rul. 85-45 (1985-1 C.B. 
183) regarding treatment of sales of property by certain trusts. Rev. 
Rul. 66-159 holds that, in cases in which the grantor is treated as the 
owner of the entire trust under sections 676 and 671, gain realized 
from the sale of trust property used by the grantor as the grantor's 
principal residence qualifies under section 1034 for the rollover of 
gain into a replacement residence. Because the grantor is treated as 
the owner of the entire trust, the sale by the trust will be treated 
for federal income tax purposes as if made by the grantor.
    Rev. Rul. 85-45 holds that, in cases in which the beneficiary of a 
trust is treated as the owner of the entire trust under sections 678 
and 671, gain realized from the sale of trust property used by the 
beneficiary as the beneficiary's principal residence qualifies for the 
one-time exclusion of gain from the sale of a residence under former 
section 121. For the period that the beneficiary is treated as the 
owner of the entire trust, the beneficiary will be treated as owning 
the property for section 121 purposes, and the sale by the trust will 
be treated for federal income tax purposes as if made by the 
beneficiary.
    The final regulations adopt these suggestions and provide that, if 
a residence is held by a trust, a taxpayer is treated as the owner and 
the seller of the residence during the period that the taxpayer is 
treated as the owner of the trust or the portion of the trust that 
includes the residence under sections 671 through 679. The regulations 
provide similar treatment for certain single-owner entities.

4. Dollar Limitations Applicable to Jointly Owned Property

    Commentators requested further clarification of the application of 
the dollar limitations of section 121(b) to non-married taxpayers who 
are joint owners of a residence. In response, the final regulations 
provide that each unmarried taxpayer who jointly owns a principal 
residence may be eligible to exclude from gross income up to $250,000 
of gain that is attributable to each taxpayer's interest in the 
property.

5. Reduced Maximum Exclusion

    Section 121(c) provides an exclusion of gain in a reduced maximum 
amount for taxpayers who have owned or used a principal residence for 
less than two of the five years preceding the sale or exchange or who 
have excluded gain from another sale or exchange during the last two 
years. Taxpayers who fail to meet any of these conditions may qualify 
for the reduced maximum exclusion if the sale or exchange is by reason 
of a change in place of employment, health, or unforeseen 
circumstances.
    The proposed regulations explain the general rule and the 
computation of the reduced maximum exclusion but do not provide rules 
clarifying what is a sale or exchange by reason of a change in place of 
employment, health, or unforeseen circumstances. Comments were 
requested regarding what circumstances should qualify as unforeseen. 
Because the rules formulated in response to the comments are extensive, 
the IRS and Treasury Department have concluded that it is appropriate 
to publish proposed and temporary regulations to provide the public 
with adequate notice and opportunity to comment. These proposed and 
temporary regulations are published elsewhere in this issue of the 
Federal Register. The final regulations provide guidance regarding the 
computation of the reduced maximum exclusion.

6. Property of Deceased Spouse

    Commentators suggested that the regulations allow a surviving 
spouse to exclude up to $500,000 of gain if the sale or exchange of the 
marital home occurs within one year of the death of the decedent spouse 
and the requirements of section 121 are otherwise met. Under section 
121(b)(2), the $500,000 exclusion is only available to spouses who file 
a joint return. A surviving spouse is eligible to file a joint return 
with the decedent spouse only for the year of the decedent spouse's 
death. Therefore, the final regulations do not adopt this suggestion.
    Commentators also requested clarification regarding the computation 
of basis and gain for surviving spouses. They asked for guidance 
regarding the advantages of titling the marital home in the names of 
both spouses so that a surviving spouse can obtain a step-up in basis 
and, consequently, realize less gain from the disposition of the 
marital home. Because the rules regarding the computation of basis and 
gain are outside the scope of these regulations, the final regulations 
do not address these issues.

7. Partial Interests

    Commentators suggested that the regulations clarify that a taxpayer 
who sells a partial interest in the taxpayer's principal residence and 
more than two years later sells the remaining interest in the same 
property is entitled to use up to the full exclusion for each sale.
    The final regulations provide that a taxpayer may exclude gain from 
the sale or exchange of partial interests (other than interests 
remaining after the sale or exchange of a remainder interest) in the 
taxpayer's principal residence if the interest sold or exchanged 
includes an interest in the dwelling unit.
    However, the IRS and Treasury Department believe that allowing more 
than the maximum limitation amount with respect to the same principal 
residence is contrary to the language and intent of section 121. 
Therefore, only one maximum limitation amount of $250,000 ($500,000 for 
certain joint returns) applies to the combined sales or exchanges of 
partial interests.

[[Page 78361]]

    In this regard, for purposes of determining the maximum limitation 
amount under section 121(b)(1) and (2), the sales or exchanges of 
partial interests in the same principal residence are treated as one 
sale or exchange. In applying the maximum limitation amount to sales or 
exchanges that occur in different taxable years, a taxpayer may exclude 
gain from the first sale or exchange of a partial interest up to the 
taxpayer's full maximum limitation amount and may exclude gain from the 
sale or exchange of any other partial interest in the same principal 
residence to the extent of any remaining maximum limitation amount, and 
each spouse is treated as excluding one-half of the gain from a sale or 
exchange to which section 121(b)(2)(A) and Sec.  1.121-2(a)(3)(i) 
(relating to the limitation for certain joint returns) apply.
    For purposes of applying section 121(b)(3) (restricting the 
application of section 121 to only 1 sale or exchange every 2 years), 
each sale or exchange of a partial interest is disregarded with respect 
to other sales or exchanges of partial interests in the same principal 
residence, but is taken into account as of the date of the sale or 
exchange in applying section 121(b)(3) to that sale or exchange and the 
sale or exchange of any other principal residence.

8. Elections Under Sections 121(d)(8) and (f)

    Commentators asked for clarification regarding when a taxpayer may 
make or revoke an election under section 121(d)(8) (election to have 
the section 121 exclusion apply to a sale or exchange of a remainder 
interest in the taxpayer's principal residence) or section 121(f) 
(election to have the section 121 exclusion not apply to a sale or 
exchange of the taxpayer's principal residence). The final regulations 
adopt and clarify the provisions of the proposed regulations and 
provide that a taxpayer may make or revoke either election at any time 
before the expiration of a three-year period beginning on the last date 
prescribed by law (determined without regard to extensions) for the 
filing of the return for the taxable year in which the sale or exchange 
occurred.

9. Reporting Sales or Exchanges

    Commentators recommended the creation of a form for taxpayers to 
use to report the sale or exchange of a principal residence even if the 
gain is entirely excludable under section 121. The final regulations do 
not adopt this suggestion because, unlike sales or exchanges under 
section 1034, no tax attributes of the sold residence carry over to a 
new residence. Therefore the reporting of excluded gain is unnecessary 
and would be unduly burdensome for taxpayers.

10. Election To Apply Regulations Retroactively

    The regulations provide that taxpayers who would otherwise qualify 
under the provisions of Sec. Sec.  1.121-1 through 1.121-4 of the final 
regulations to exclude gain from a sale or exchange before the 
effective date of the regulations but on or after May 7, 1997, may 
elect to apply the provisions of the final regulations for any years 
for which the period of limitation under section 6511 has not expired. 
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 the provisions 
of the final regulations for any years for which the period of 
limitation under section 6511 has not expired by filing an amended 
return.

11. Audit Protection

    The 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 
section 121 exclusion if the taxpayer has made a reasonable, good faith 
effort to comply with the requirements of section 121. Compliance with 
the provisions of the proposed regulations that preceded these final 
regulations generally will be considered a reasonable, good faith 
effort.

12. Section 121 Exclusion in Individuals' Title 11 Cases

    The regulations provide that the bankruptcy estate of an individual 
in a chapter 7 or 11 bankruptcy case under title 11 of the United 
States Code succeeds to and takes into account the individual's section 
121 exclusion if the individual satisfies the requirements of section 
121. Although the effective date for this provision is on or after 
publication of final regulations in the Federal Register, in view of 
the IRS's acquiescence in the case of Internal Revenue Service v. 
Waldschmidt (In re Bradley), 222 B.R. 313 (M.D. Tenn. 1998), AOD CC-
1999-009 (August 30, 1999), and Chief Counsel Notice (35)000-162 
(August 10, 1999), the IRS will not challenge a position taken prior to 
the effective date of these regulations that a bankruptcy estate may 
use the section 121 exclusion if the debtor would otherwise satisfy the 
section 121 requirements.

13. Effective Date

    These regulations apply to sales or exchanges on or after December 
24, 2002.

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, and because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its 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 is amended by adding 
an entry in numerical order to read in part as follows:

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

    Section 1.1398-3 also issued under 26 U.S.C. 1398(g) * * *

    Par. 2. Sections 1.121-1, 1.121-2, 1.121-3 and 1.121-4 are revised 
to read as follows:


Sec.  1.121-1  Exclusion of gain from sale or exchange of a principal 
residence.

    (a) In general. Section 121 provides that, under certain 
circumstances, gross income does not include gain realized on the sale 
or exchange of property that was owned and used by a taxpayer as the 
taxpayer's principal residence. Subject to the other provisions of

[[Page 78362]]

section 121, a taxpayer may exclude gain only if, during the 5-year 
period ending on the date of the sale or exchange, the taxpayer owned 
and used the property as the taxpayer's principal residence for periods 
aggregating 2 years or more.
    (b) Residence--(1) In general. Whether property is used by the 
taxpayer as the taxpayer's residence depends upon all the facts and 
circumstances. A property used by the taxpayer as the taxpayer's 
residence may include a houseboat, a house trailer, or the house or 
apartment that the taxpayer is entitled to occupy as a tenant-
stockholder in a cooperative housing corporation (as those terms are 
defined in section 216(b)(1) and (2)). Property used by the taxpayer as 
the taxpayer's residence does not include personal property that is not 
a fixture under local law.
    (2) Principal residence. In the case of a taxpayer using more than 
one property as a residence, whether property is used by the taxpayer 
as the taxpayer's principal residence depends upon all the facts and 
circumstances. If a taxpayer alternates between 2 properties, using 
each as a residence for successive periods of time, the property that 
the taxpayer uses a majority of the time during the year ordinarily 
will be considered the taxpayer's principal residence. In addition to 
the taxpayer's use of the property, relevant factors in determining a 
taxpayer's principal residence, include, but are not limited to--
    (i) The taxpayer's place of employment;
    (ii) The principal place of abode of the taxpayer's family members;
    (iii) The address listed on the taxpayer's federal and state tax 
returns, driver's license, automobile registration, and voter 
registration card;
    (iv) The taxpayer's mailing address for bills and correspondence;
    (v) The location of the taxpayer's banks; and
    (vi) The location of religious organizations and recreational clubs 
with which the taxpayer is affiliated.
    (3) Vacant land--(i) In general. The sale or exchange of vacant 
land is not a sale or exchange of the taxpayer's principal residence 
unless--
    (A) The vacant land is adjacent to land containing the dwelling 
unit of the taxpayer's principal residence;
    (B) The taxpayer owned and used the vacant land as part of the 
taxpayer's principal residence;
    (C) The taxpayer sells or exchanges the dwelling unit in a sale or 
exchange that meets the requirements of section 121 within 2 years 
before or 2 years after the date of the sale or exchange of the vacant 
land; and
    (D) The requirements of section 121 have otherwise been met with 
respect to the vacant land.
    (ii) Limitations--(A) Maximum limitation amount. For purposes of 
section 121(b)(1) and (2) (relating to the maximum limitation amount of 
the section 121 exclusion), the sale or exchange of the dwelling unit 
and the vacant land are treated as one sale or exchange. Therefore, 
only one maximum limitation amount of $250,000 ($500,000 for certain 
joint returns) applies to the combined sales or exchanges of vacant 
land and the dwelling unit. In applying the maximum limitation amount 
to sales or exchanges that occur in different taxable years, gain from 
the sale or exchange of the dwelling unit, up to the maximum limitation 
amount under section 121(b)(1) or (2), is excluded first and each 
spouse is treated as excluding one-half of the gain from a sale or 
exchange to which section 121(b)(2)(A) and Sec.  1.121-2(a)(3)(i) 
(relating to the limitation for certain joint returns) apply.
    (B) Sale or exchange of more than one principal residence in 2-year 
period. If a dwelling unit and vacant land are sold or exchanged in 
separate transactions that qualify for the section 121 exclusion under 
this paragraph (b)(3), each of the transactions is disregarded in 
applying section 121(b)(3) (restricting the application of section 121 
to only 1 sale or exchange every 2 years) to the other transactions but 
is taken into account as a sale or exchange of a principal residence on 
the date of the transaction in applying section 121(b)(3) to that 
transaction and the sale or exchange of any other principal residence.
    (C) Sale or exchange of vacant land before dwelling unit. If the 
sale or exchange of the dwelling unit occurs in a later taxable year 
than the sale or exchange of the vacant land and after the date 
prescribed by law (including extensions) for the filing of the return 
for the taxable year of the sale or exchange of the vacant land, any 
gain from the sale or exchange of the vacant land must be treated as 
taxable on the taxpayer's return for the taxable year of the sale or 
exchange of the vacant land. If the taxpayer has reported gain from the 
sale or exchange of the vacant land as taxable, after satisfying the 
requirements of this paragraph (b)(3) the taxpayer may claim the 
section 121 exclusion with regard to the sale or exchange of the vacant 
land (for any period for which the period of limitation under section 
6511 has not expired) by filing an amended return.
    (4) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1.  Taxpayer A owns 2 residences, one in New York and 
one in Florida. From 1999 through 2004, he lives in the New York 
residence for 7 months and the Florida residence for 5 months of 
each year. In the absence of facts and circumstances indicating 
otherwise, the New York residence is A's principal residence. A 
would be eligible for the section 121 exclusion of gain from the 
sale or exchange of the New York residence, but not the Florida 
residence.
    Example 2.  Taxpayer B owns 2 residences, one in Virginia and 
one in Maine. During 1999 and 2000, she lives in the Virginia 
residence. During 2001 and 2002, she lives in the Maine residence. 
During 2003, she lives in the Virginia residence. B's principal 
residence during 1999, 2000, and 2003 is the Virginia residence. B's 
principal residence during 2001 and 2002 is the Maine residence. B 
would be eligible for the 121 exclusion of gain from the sale or 
exchange of either residence (but not both) during 2003.
    Example 3.  In 1991 Taxpayer C buys property consisting of a 
house and 10 acres that she uses as her principal residence. In May 
2005 C sells 8 acres of the land and realizes a gain of $110,000. C 
does not sell the dwelling unit before the due date for filing C's 
2005 return, therefore C is not eligible to exclude the $110,000 of 
gain. In March 2007 C sells the house and remaining 2 acres 
realizing a gain of $180,000 from the sale of the house. C may 
exclude the $180,000 of gain. Because the sale of the 8 acres 
occurred within 2 years from the date of the sale of the dwelling 
unit, the sale of the 8 acres is treated as a sale of the taxpayer's 
principal residence under paragraph (b)(3) of this section. C may 
file an amended return for 2005 to claim an exclusion for $70,000 
($250,000-$180,000 gain previously excluded) of the $110,000 gain 
from the sale of the 8 acres.
    Example 4.  In 1998 Taxpayer D buys a house and 1 acre that he 
uses as his principal residence. In 1999 D buys 29 acres adjacent to 
his house and uses the vacant land as part of his principal 
residence. In 2003 D sells the house and 1 acre and the 29 acres in 
2 separate transactions. D sells the house and 1 acre at a loss of 
$25,000. D realizes $270,000 of gain from the sale of the 29 acres. 
D may exclude the $245,000 gain from the 2 sales.

    (c) Ownership and use requirements--(1) In general. The 
requirements of ownership and use for periods aggregating 2 years or 
more may be satisfied by establishing ownership and use for 24 full 
months or for 730 days (365 x 2). The requirements of ownership and use 
may be satisfied during nonconcurrent periods if both the ownership and 
use tests are met during the 5-year period ending on the date of the 
sale or exchange.
    (2) Use. (i) In establishing whether a taxpayer has satisfied the 
2-year use

[[Page 78363]]

requirement, occupancy of the residence is required. However, short 
temporary absences, such as for vacation or other seasonal absence 
(although accompanied with rental of the residence), are counted as 
periods of use.
    (ii) Determination of use during periods of out-of-residence care. 
If a taxpayer has become physically or mentally incapable of self-care 
and the taxpayer sells or exchanges property that the taxpayer owned 
and used as the taxpayer's principal residence for periods aggregating 
at least 1 year during the 5-year period preceding the sale or 
exchange, the taxpayer is treated as using the property as the 
taxpayer's principal residence for any period of time during the 5-year 
period in which the taxpayer owns the property and resides in any 
facility (including a nursing home) licensed by a State or political 
subdivision to care for an individual in the taxpayer's condition.
    (3) Ownership--(i) Trusts. If a residence is owned by a trust, for 
the period that a taxpayer is treated under sections 671 through 679 
(relating to the treatment of grantors and others as substantial 
owners) as the owner of the trust or the portion of the trust that 
includes the residence, the taxpayer will be treated as owning the 
residence for purposes of satisfying the 2-year ownership requirement 
of section 121, and the sale or exchange by the trust will be treated 
as if made by the taxpayer.
    (ii) Certain single owner entities. If a residence is owned by an 
eligible entity (within the meaning of Sec.  301.7701-3(a) of this 
chapter) that has a single owner and is disregarded for federal tax 
purposes as an entity separate from its owner under Sec.  301.7701-3 of 
this chapter, the owner will be treated as owning the residence for 
purposes of satisfying the 2-year ownership requirement of section 121, 
and the sale or exchange by the entity will be treated as if made by 
the owner.
    (4) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples. The examples assume that Sec.  1.121-3 
(relating to the reduced maximum exclusion) does not apply to the sale 
of the property. The examples are as follows:

    Example 1.  Taxpayer A has owned and used his house as his 
principal residence since 1986. On January 31, 1998, A moves to 
another state. A rents his house to tenants from that date until 
April 18, 2000, when he sells it. A is eligible for the section 121 
exclusion because he has owned and used the house as his principal 
residence for at least 2 of the 5 years preceding the sale.
    Example 2.  Taxpayer B owns and uses a house as her principal 
residence from 1986 to the end of 1997. On January 4, 1998, B moves 
to another state and ceases to use the house. B's son moves into the 
house in March 1999 and uses the residence until it is sold on July 
1, 2001. B may not exclude gain from the sale under section 121 
because she did not use the property as her principal residence for 
at least 2 years out of the 5 years preceding the sale.
    Example 3.  Taxpayer C lives in a townhouse that he rents from 
1993 through 1996. On January 18, 1997, he purchases the townhouse. 
On February 1, 1998, C moves into his daughter's home. On May 25, 
2000, while still living in his daughter's home, C sells his 
townhouse. The section 121 exclusion will apply to gain from the 
sale because C owned the townhouse for at least 2 years out of the 5 
years preceding the sale (from January 19, 1997 until May 25, 2000) 
and he used the townhouse as his principal residence for at least 2 
years during the 5-year period preceding the sale (from May 25, 1995 
until February 1, 1998).
    Example 4.  Taxpayer D, a college professor, purchases and moves 
into a house on May 1, 1997. He uses the house as his principal 
residence continuously until September 1, 1998, when he goes abroad 
for a 1-year sabbatical leave. On October 1, 1999, 1 month after 
returning from the leave, D sells the house. Because his leave is 
not considered to be a short temporary absence under paragraph 
(c)(2) of this section, the period of the sabbatical leave may not 
be included in determining whether D used the house for periods 
aggregating 2 years during the 5-year period ending on the date of 
the sale. Consequently, D is not entitled to exclude gain under 
section 121 because he did not use the residence for the requisite 
period.
    Example 5.  Taxpayer E purchases a house on February 1, 1998, 
that he uses as his principal residence. During 1998 and 1999, E 
leaves his residence for a 2-month summer vacation. E sells the 
house on March 1, 2000. Although, in the 5-year period preceding the 
date of sale, the total time E used his residence is less than 2 
years (21 months), the section 121 exclusion will apply to gain from 
the sale of the residence because, under paragraph (c)(2) of this 
section, the 2-month vacations are short temporary absences and are 
counted as periods of use in determining whether E used the 
residence for the requisite period.

    (d) Depreciation taken after May 6, 1997--(1) In general. The 
section 121 exclusion does not apply to so much of the gain from the 
sale or exchange of property as does not exceed the portion of the 
depreciation adjustments (as defined in section 1250(b)(3)) 
attributable to the property for periods after May 6, 1997. 
Depreciation adjustments allocable to any portion of the property to 
which the section 121 exclusion does not apply under paragraph (e) of 
this section are not taken into account for this purpose.
    (2) Example. The provisions of this paragraph (d) are illustrated 
by the following example:

    Example.  On July 1, 1999, Taxpayer A moves into a house that he 
owns and had rented to tenants since July 1, 1997. A took 
depreciation deductions totaling $14,000 for the period that he 
rented the property. After using the residence as his principal 
residence for 2 full years, A sells the property on August 1, 2001. 
A's gain realized from the sale is $40,000. A has no other section 
1231 or capital gains or losses for 2001. Only $26,000 ($40,000 gain 
realized--$14,000 depreciation deductions) may be excluded under 
section 121. Under section 121(d)(6) and paragraph (d)(1) of this 
section, A must recognize $14,000 of the gain as unrecaptured 
section 1250 gain within the meaning of section 1(h).

    (e) Property used in part as a principal residence--(1) Allocation 
required. Section 121 will not apply to the gain allocable to any 
portion (separate from the dwelling unit) of property sold or exchanged 
with respect to which a taxpayer does not satisfy the use requirement. 
Thus, if a portion of the property was used for residential purposes 
and a portion of the property (separate from the dwelling unit) was 
used for non-residential purposes, only the gain allocable to the 
residential portion is excludable under section 121. No allocation is 
required if both the residential and non-residential portions of the 
property are within the same dwelling unit. However, section 121 does 
not apply to the gain allocable to the residential portion of the 
property to the extent provided by paragraph (d) of this section.
    (2) Dwelling unit. For purposes of this paragraph (e), the term 
dwelling unit has the same meaning as in section 280A(f)(1), but does 
not include appurtenant structures or other property.
    (3) Method of allocation. For purposes of determining the amount of 
gain allocable to the residential and non-residential portions of the 
property, the taxpayer must allocate the basis and the amount realized 
between the residential and the non-residential portions of the 
property using the same method of allocation that the taxpayer used to 
determine depreciation adjustments (as defined in section 1250(b)(3)), 
if applicable.
    (4) Examples. The provisions of this paragraph (e) are illustrated 
by the following examples:

    Example 1. Non-residential use of property not within the 
dwelling unit. (i) Taxpayer A owns a property that consists of a 
house, a stable and 35 acres. A uses the stable and 28 acres for 
non-residential purposes for more than 3 years during the 5-year 
period preceding the sale. A uses the entire house

[[Page 78364]]

and the remaining 7 acres as his principal residence for at least 2 
years during the 5-year period preceding the sale. For periods after 
May 6, 1997, A claims depreciation deductions of $9,000 for the non-
residential use of the stable. A sells the entire property in 2004, 
realizing a gain of $24,000. A has no other section 1231 or capital 
gains or losses for 2004.
    (ii) Because the stable and the 28 acres used in the business 
are separate from the dwelling unit, the allocation rules under this 
paragraph (e) apply and A must allocate the basis and amount 
realized between the portion of the property that he used as his 
principal residence and the portion of the property that he used for 
non-residential purposes. A determines that $14,000 of the gain is 
allocable to the non-residential-use portion of the property and 
that $10,000 of the gain is allocable to the portion of the property 
used as his residence. A must recognize the $14,000 of gain 
allocable to the non-residential-use portion of the property ($9,000 
of which is unrecaptured section 1250 gain within the meaning of 
section 1(h), and $5,000 of which is adjusted net capital gain). A 
may exclude $10,000 of the gain from the sale of the property.
    Example 2. Non-residential use of property not within the 
dwelling unit and rental of the entire property. (i) In 1998 
Taxpayer B buys a property that includes a house, a barn, and 2 
acres. B uses the house and 2 acres as her principal residence and 
the barn for an antiques business. In 2002, B moves out of the house 
and rents it to tenants. B sells the property in 2004, realizing a 
gain of $21,000. Between 1998 and 2004 B claims depreciation 
deductions of $4,800 attributable to the antiques business. Between 
2002 and 2004 B claims depreciation deductions of $3,000 
attributable to the house. B has no other section 1231 or capital 
gains or losses for 2004.
    (ii) Because the portion of the property used in the antiques 
business is separate from the dwelling unit, the allocation rules 
under this paragraph (e) apply. B must allocate basis and amount 
realized between the portion of the property that she used as her 
principal residence and the portion of the property that she used 
for non-residential purposes. B determines that $4,000 of the gain 
is allocable to the non-residential portion of the property and that 
$17,000 of the gain is allocable to the portion of the property that 
she used as her principal residence.
    (iii) B must recognize the $4,000 of gain allocable to the non-
residential portion of the property (all of which is unrecaptured 
section 1250 gain within the meaning of section 1(h)). In addition, 
the section 121 exclusion does not apply to the gain allocable to 
the residential portion of the property to the extent of the 
depreciation adjustments attributable to the residential portion of 
the property for periods after May 6, 1997 ($3,000). Therefore, B 
may exclude $14,000 of the gain from the sale of the property.
    Example 3. Non-residential use of a separate dwelling unit. (i) 
In 2002 Taxpayer C buys a 3-story townhouse and converts the 
basement level, which has a separate entrance, into a separate 
apartment by installing a kitchen and bathroom and removing the 
interior stairway that leads from the basement to the upper floors. 
After the conversion, the property constitutes 2 dwelling units 
within the meaning of paragraph (e)(2) of this section. C uses the 
first and second floors of the townhouse as his principal residence 
and rents the basement level to tenants from 2003 to 2007. C claims 
depreciation deductions of $2,000 for that period with respect to 
the basement apartment. C sells the entire property in 2007, 
realizing gain of $18,000. C has no other section 1231 or capital 
gains or losses for 2007.
    (ii) Because the basement apartment and the upper floors of the 
townhouse are separate dwelling units, C must allocate the gain 
between the portion of the property that he used as his principal 
residence and the portion of the property that he used for non-
residential purposes under paragraph (e) of this section. After 
allocating the basis and the amount realized between the residential 
and non-residential portions of the property, C determines that 
$6,000 of the gain is allocable to the non-residential portion of 
the property and that $12,000 of the gain is allocable to the 
portion of the property used as his residence. C must recognize the 
$6,000 of gain allocable to the non-residential portion of the 
property ($2,000 of which is unrecaptured section 1250 gain within 
the meaning of section 1(h), and $4,000 of which is adjusted net 
capital gain). C may exclude $12,000 of the gain from the sale of 
the property.
    Example 4. Separate dwelling unit converted to residential use. 
The facts are the same as in Example 3 except that in 2007 C 
incorporates the basement of the townhouse into his principal 
residence by eliminating the kitchen and building a new interior 
stairway to the upper floors. C uses all 3 floors of the townhouse 
as his principal residence for 2 full years and sells the townhouse 
in 2010, realizing a gain of $20,000. Under section 121(d)(6) and 
paragraph (d) of this section, C must recognize $2,000 of the gain 
as unrecaptured section 1250 gain within the meaning of section 
1(h). Because C used the entire 3 floors of the townhouse as his 
principal residence for 2 of the 5 years preceding the sale of the 
property, C may exclude the remaining $18,000 of the gain from the 
sale of the house.
    Example 5. Non-residential use within the dwelling unit, 
property depreciated. Taxpayer D, an attorney, buys a house in 2003. 
The house constitutes a single dwelling unit but D uses a portion of 
the house as a law office. D claims depreciation deductions of 
$2,000 during the period that she owns the house. D sells the house 
in 2006, realizing a gain of $13,000. D has no other section 1231 or 
capital gains or losses for 2006. Under section 121(d)(6) and 
paragraph (d) of this section, D must recognize $2,000 of the gain 
as unrecaptured section 1250 gain within the meaning of section 
1(h). D may exclude the remaining $11,000 of the gain from the sale 
of her house because, under paragraph (e)(1) of this section, she is 
not required to allocate gain to the business use within the 
dwelling unit.
    Example 6. Non-residential use within the dwelling unit, 
property not depreciated. The facts are the same as in Example 5, 
except that D is not entitled to claim any depreciation deductions 
with respect to her business use of the house. D may exclude $13,000 
of the gain from the sale of her house because, under paragraph 
(e)(1) of this section, she is not required to allocate gain to the 
business use within the dwelling unit.

    (f) Effective date. This section is applicable for sales and 
exchanges on or after Decmeber 24, 2002. For rules on electing to apply 
the provisions of this section retroactively, see Sec.  1.121-4(j).


Sec.  1.121-2  Limitations.

    (a) Dollar limitations--(1) In general. A taxpayer may exclude from 
gross income up to $250,000 of gain from the sale or exchange of the 
taxpayer's principal residence. A taxpayer is eligible for only one 
maximum exclusion per principal residence.
    (2) Joint owners. If taxpayers jointly own a principal residence 
but file separate returns, each taxpayer may exclude from gross income 
up to $250,000 of gain that is attributable to each taxpayer's interest 
in the property, if the requirements of section 121 have otherwise been 
met.
    (3) Special rules for joint returns--(i) In general. A husband and 
wife who make a joint return for the year of the sale or exchange of a 
principal residence may exclude up to $500,000 of gain if--
    (A) Either spouse meets the 2-year ownership requirements of Sec.  
1.121-1(a) and (c);
    (B) Both spouses meet the 2-year use requirements of Sec.  1.121-
1(a) and (c); and
    (C) Neither spouse excluded gain from a prior sale or exchange of 
property under section 121 within the last 2 years (as determined under 
paragraph (b) of this section).
    (ii) Other joint returns. For taxpayers filing jointly, if either 
spouse fails to meet the requirements of paragraph (a)(3)(i) of this 
section, the maximum limitation amount to be claimed by the couple is 
the sum of each spouse's limitation amount determined on a separate 
basis as if they had not been married. For this purpose, each spouse is 
treated as owning the property during the period that either spouse 
owned the property.
    (4) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples. The examples assume that Sec.  1.121-3 
(relating to the reduced maximum exclusion) does not apply to the sale 
of the property. The examples are as follows:

    Example 1. Unmarried Taxpayers A and B own a house as joint 
owners, each owning a

[[Page 78365]]

50 percent interest in the house. They sell the house after owning 
and using it as their principal residence for 2 full years. The gain 
realized from the sale is $256,000. A and B are each eligible to 
exclude $128,000 of gain because the amount of realized gain 
allocable to each of them from the sale does not exceed each 
taxpayer's available limitation amount of $250,000.
    Example 2. The facts are the same as in Example 1, except that A 
and B are married taxpayers who file a joint return for the taxable 
year of the sale. A and B are eligible to exclude the entire amount 
of realized gain ($256,000) from gross income because the gain 
realized from the sale does not exceed the limitation amount of 
$500,000 available to A and B as taxpayers filing a joint return.
    Example 3. During 1999, married Taxpayers H and W each sell a 
residence that each had separately owned and used as a principal 
residence before their marriage. Each spouse meets the ownership and 
use tests for his or her respective residence. Neither spouse meets 
the use requirement for the other spouse's residence. H and W file a 
joint return for the year of the sales. The gain realized from the 
sale of H's residence is $200,000. The gain realized from the sale 
of W's residence is $300,000. Because the ownership and use 
requirements are met for each residence by each respective spouse, H 
and W are each eligible to exclude up to $250,000 of gain from the 
sale of their individual residences. However, W may not use H's 
unused exclusion to exclude gain in excess of her limitation amount. 
Therefore, H and W must recognize $50,000 of the gain realized on 
the sale of W's residence.
    Example 4. Married Taxpayers H and W sell their residence and 
file a joint return for the year of the sale. W, but not H, 
satisfies the requirements of section 121. They are eligible to 
exclude up to $250,000 of the gain from the sale of the residence 
because that is the sum of each spouse's dollar limitation amount 
determined on a separate basis as if they had not been married ($0 
for H, $250,000 for W).
    Example 5. Married Taxpayers H and W have owned and used their 
principal residence since 1998. On February 16, 2001, H dies. On 
September 24, 2001, W sells the residence and realizes a gain of 
$350,000. Pursuant to section 6013(a)(3), W and H's executor make a 
joint return for 2001. All $350,000 of the gain from the sale of the 
residence may be excluded.
    Example 6. Assume the same facts as Example 5, except that W 
does not sell the residence until January 31, 2002. Because W's 
filing status for the taxable year of the sale is single, the 
special rules for joint returns under paragraph (a)(3) of this 
section do not apply and W may exclude only $250,000 of the gain.

    (b) Application of section 121 to only 1 sale or exchange every 2 
years--(1) In general. Except as otherwise provided in Sec.  1.121-3 
(relating to the reduced maximum exclusion), a taxpayer may not exclude 
from gross income gain from the sale or exchange of a principal 
residence if, during the 2-year period ending on the date of the sale 
or exchange, the taxpayer sold or exchanged other property for which 
gain was excluded under section 121. For purposes of this paragraph 
(b)(1), any sale or exchange before May 7, 1997, is disregarded.
    (2) Example. The following example illustrates the rules of this 
paragraph (b). The example assumes that Sec.  1.121-3 (relating to the 
reduced maximum exclusion) does not apply to the sale of the property. 
The example is as follows:

    Example. Taxpayer A owns a townhouse that he uses as his 
principal residence for 2 full years, 1998 and 1999. A buys a house 
in 2000 that he owns and uses as his principal residence. A sells 
the townhouse in 2002 and excludes gain realized on its sale under 
section 121. A sells the house in 2003. Although A meets the 2-year 
ownership and use requirements of section 121, A is not eligible to 
exclude gain from the sale of the house because A excluded gain 
within the last 2 years under section 121 from the sale of the 
townhouse.

    (c) Effective date. This section is applicable for sales and 
exchanges on or after December 24, 2002. For rules on electing to apply 
the provisions of this section retroactively, see Sec.  1.121-4(j).


Sec.  1.121-3  Reduced maximum exclusion for taxpayers failing to meet 
certain requirements.

    (a) In general. In lieu of the limitation under section 121(b) and 
Sec.  1.121-2, a reduced maximum exclusion limitation may be available 
for a taxpayer who sells or exchanges property used as the taxpayer's 
principal residence but fails to satisfy the ownership and use 
requirements described in Sec.  1.121-1(a) and (c) or the 2-year 
limitation described in Sec.  1.121-2(b).
    (b) through (f) [Reserved]. For further guidance, see Sec.  1.121-
3T(b) through (f).
    (g) Computation of reduced maximum exclusion. (1) The reduced 
maximum exclusion is computed by multiplying the maximum dollar 
limitation of $250,000 ($500,000 for certain joint filers) by a 
fraction. The numerator of the fraction is the shortest of the period 
of time that the taxpayer owned the property during the 5-year period 
ending on the date of the sale or exchange; the period of time that the 
taxpayer used the property as the taxpayer's principal residence during 
the 5-year period ending on the date of the sale or exchange; or the 
period of time between the date of a prior sale or exchange of property 
for which the taxpayer excluded gain under section 121 and the date of 
the current sale or exchange. The numerator of the fraction may be 
expressed in days or months. The denominator of the fraction is 730 
days or 24 months (depending on the measure of time used in the 
numerator).
    (2) Examples. The following examples illustrate the rules of this 
paragraph (g):

    Example 1. Taxpayer A purchases a house that she uses as her 
principal residence. Twelve months after the purchase, A sells the 
house due to a change in place of her employment. A has not excluded 
gain under section 121 on a prior sale or exchange of property 
within the last 2 years. A is eligible to exclude up to $125,000 of 
the gain from the sale of her house (12/24 x $250,000).
    Example 2. (i) Taxpayer H owns a house that he has used as his 
principal residence since 1996. On January 15, 1999, H and W marry 
and W begins to use H's house as her principal residence. On January 
15, 2000, H sells the house due to a change in W's place of 
employment. Neither H nor W has excluded gain under section 121 on a 
prior sale or exchange of property within the last 2 years.
    (ii) Because H and W have not each used the house as their 
principal residence for at least 2 years during the 5-year period 
preceding its sale, the maximum dollar limitation amount that may be 
claimed by H and W will not be $500,000, but the sum of each 
spouse's limitation amount determined on a separate basis as if they 
had not been married. (See Sec.  1.121-2(a)(3)(ii).)
    (iii) H is eligible to exclude up to $250,000 of gain because he 
meets the requirements of section 121. W is not eligible to exclude 
the maximum dollar limitation amount. Instead, because the sale of 
the house is due to a change in place of employment, W is eligible 
to claim a reduced maximum exclusion of up to $125,000 of the gain 
(365/730 x $250,000). Therefore, H and W are eligible to exclude up 
to $375,000 of gain ($250,000 + $125,000) from the sale of the 
house.

    (h) [Reserved]. For further guidance, see Sec.  1.121-3T(h).
    (i) through (k) [Reserved].
    (l) Effective date. This section is applicable for sales and 
exchanges on or after December 24, 2002. For rules on electing to apply 
the provisions of this section retroactively, see Sec.  1.121-4(j).


Sec.  1.121-4  Special rules.

    (a) Property of deceased spouse--(1) In general. For purposes of 
satisfying the ownership and use requirements of section 121, a 
taxpayer is treated as owning and using property as the taxpayer's 
principal residence during any period that the taxpayer's deceased 
spouse owned and used the property as a principal residence before 
death if--
    (i) The taxpayer's spouse is deceased on the date of the sale or 
exchange of the property; and
    (ii) The taxpayer has not remarried at the time of the sale or 
exchange of the property.
    (2) Example. The provisions of this paragraph (a) are illustrated 
by the following example. The example assumes that Sec.  1.121-3 
(relating to the reduced maximum exclusion) does not apply to the sale 
of the property. The example is as follows:


[[Page 78366]]


    Example. Taxpayer H has owned and used a house as his principal 
residence since 1987. H and W marry on July 1, 1999 and from that 
date they use H's house as their principal residence. H dies on 
August 15, 2000, and W inherits the property. W sells the property 
on September 1, 2000, at which time she has not remarried. Although 
W has owned and used the house for less than 2 years, W will be 
considered to have satisfied the ownership and use requirements of 
section 121 because W's period of ownership and use includes the 
period that H owned and used the property before death.

    (b) Property owned by spouse or former spouse--(1) Property 
transferred to individual from spouse or former spouse. If a taxpayer 
obtains property from a spouse or former spouse in a transaction 
described in section 1041(a), the period that the taxpayer owns the 
property will include the period that the spouse or former spouse owned 
the property.
    (2) Property used by spouse or former spouse. A taxpayer is treated 
as using property as the taxpayer's principal residence for any period 
that the taxpayer has an ownership interest in the property and the 
taxpayer's spouse or former spouse is granted use of the property under 
a divorce or separation instrument (as defined in section 71(b)(2)), 
provided that the spouse or former spouse uses the property as his or 
her principal residence.
    (c) Tenant-stockholder in cooperative housing corporation. A 
taxpayer who holds stock as a tenant-stockholder in a cooperative 
housing corporation (as those terms are defined in sections 216(b)(1) 
and (2)) may be eligible to exclude gain under section 121 on the sale 
or exchange of the stock. In determining whether the taxpayer meets the 
requirements of section 121, the ownership requirements are applied to 
the holding of the stock and the use requirements are applied to the 
house or apartment that the taxpayer is entitled to occupy by reason of 
the taxpayer's stock ownership.
    (d) Involuntary conversions--(1) In general. For purposes of 
section 121, the destruction, theft, seizure, requisition, or 
condemnation of property is treated as a sale of the property.
    (2) Application of section 1033. In applying section 1033 (relating 
to involuntary conversions), the amount realized from the sale or 
exchange of property used as the taxpayer's principal residence is 
treated as being the amount determined without regard to section 121, 
reduced by the amount of gain excluded from the taxpayer's gross income 
under section 121.
    (3) Property acquired after involuntary conversion. If the basis of 
the property acquired as a result of an involuntary conversion is 
determined (in whole or in part) under section 1033(b) (relating to the 
basis of property acquired through an involuntary conversion), then for 
purposes of satisfying the requirements of section 121, the taxpayer 
will be treated as owning and using the acquired property as the 
taxpayer's principal residence during any period of time that the 
taxpayer owned and used the converted property as the taxpayer's 
principal residence.
    (4) Example. The provisions of this paragraph (d) are illustrated 
by the following example:

    Example. (i) On February 18, 1999, fire destroys Taxpayer A's 
house which has an adjusted basis of $80,000. A had owned and used 
this property as her principal residence for 20 years prior to its 
destruction. A's insurance company pays A $400,000 for the house. A 
realizes a gain of $320,000 ($400,000--$80,000). On August 27, 1999, 
A purchases a new house at a cost of $100,000.
    (ii) Because the destruction of the house is treated as a sale 
for purposes of section 121, A will exclude $250,000 of the realized 
gain from A's gross income. For purposes of section 1033, the amount 
realized is then treated as being $150,000 ($400,000--$250,000) and 
the gain realized is $70,000 ($150,000 amount realized--$80,000 
basis). A elects under section 1033 to recognize only $50,000 of the 
gain ($150,000 amount realized--$100,000 cost of new house). The 
remaining $20,000 of gain is deferred and A's basis in the new house 
is $80,000 ($100,000 cost--$20,000 gain not recognized).
    (iii) A will be treated as owning and using the new house as A's 
principal residence during the 20-year period that A owned and used 
the destroyed house.

    (e) Sales or exchanges of partial interests--(1) Partial interests 
other than remainder interests--(i) In general. Except as provided in 
paragraph (e)(2) of this section (relating to sales or exchanges of 
remainder interests), a taxpayer may apply the section 121 exclusion to 
gain from the sale or exchange of an interest in the taxpayer's 
principal residence that is less than the taxpayer's entire interest if 
the interest sold or exchanged includes an interest in the dwelling 
unit. For rules relating to the sale or exchange of vacant land, see 
Sec.  1.121-1(b)(3).
    (ii) Limitations--(A) Maximum limitation amount. For purposes of 
section 121(b)(1) and (2) (relating to the maximum limitation amount of 
the section 121 exclusion), sales or exchanges of partial interests in 
the same principal residence are treated as one sale or exchange. 
Therefore, only one maximum limitation amount of $250,000 ($500,000 for 
certain joint returns) applies to the combined sales or exchanges of 
the partial interests. In applying the maximum limitation amount to 
sales or exchanges that occur in different taxable years, a taxpayer 
may exclude gain from the first sale or exchange of a partial interest 
up to the taxpayer's full maximum limitation amount and may exclude 
gain from the sale or exchange of any other partial interest in the 
same principal residence to the extent of any remaining maximum 
limitation amount, and each spouse is treated as excluding one-half of 
the gain from a sale or exchange to which section 121(b)(2)(A) and 
Sec.  1.121-2(a)(3)(i)(relating to the limitation for certain joint 
returns) apply.
    (B) Sale or exchange of more than one principal residence in 2-year 
period. For purposes of applying section 121(b)(3) (restricting the 
application of section 121 to only 1 sale or exchange every 2 years), 
each sale or exchange of a partial interest is disregarded with respect 
to other sales or exchanges of partial interests in the same principal 
residence, but is taken into account as of the date of the sale or 
exchange in applying section 121(b)(3) to that sale or exchange and the 
sale or exchange of any other principal residence.
    (2) Sales or exchanges of remainder interests--(i) In general. A 
taxpayer may elect to apply the section 121 exclusion to gain from the 
sale or exchange of a remainder interest in the taxpayer's principal 
residence.
    (ii) Limitations--(A) Sale or exchange of any other interest. If a 
taxpayer elects to exclude gain from the sale or exchange of a 
remainder interest in the taxpayer's principal residence, the section 
121 exclusion will not apply to a sale or exchange of any other 
interest in the residence that is sold or exchanged separately.
    (B) Sales or exchanges to related parties. This paragraph (e)(2) 
will not apply to a sale or exchange to any person that bears a 
relationship to the taxpayer that is described in section 267(b) or 
707(b).
    (iii) Election. The taxpayer makes the election under this 
paragraph (e)(2) 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 remainder interest in the taxpayer's gross income. A taxpayer may 
make or revoke the election at any time before the expiration of a 3-
year period beginning on the last date prescribed by law (determined 
without regard to extensions) for the filing of the return for the 
taxable year in which the sale or exchange occurred.
    (4) Example. The provisions of this paragraph (e) are illustrated 
by the following example:


[[Page 78367]]


    Example. In 1991 Taxpayer A buys a house that A uses as his 
principal residence. In 2004 A's friend B moves into A's house and A 
sells B a 50% interest in the house realizing a gain of $136,000. A 
may exclude the $136,000 of gain. In 2005 A sells his remaining 50% 
interest in the home to B realizing a gain of $138,000. A may 
exclude $114,000 ($250,000--$136,000 gain previously excluded) of 
the $138,000 gain from the sale of the remaining interest.

    (f) No exclusion for expatriates. The section 121 exclusion will 
not apply to any sale or exchange by an individual if the provisions of 
section 877(a) (relating to the treatment of expatriates) applies to 
the individual.
    (g) Election to have section not apply. A taxpayer may elect to 
have the section 121 exclusion not apply to a sale or exchange of 
property. The taxpayer makes the election by filing a return for the 
taxable year of the sale or exchange that includes the gain from the 
sale or exchange of the taxpayer's principal residence in the 
taxpayer's gross income. A taxpayer may make an election under this 
paragraph (g) to have section 121 not apply (or revoke an election to 
have section 121 not apply) at any time before the expiration of a 3-
year period beginning on the last date prescribed by law (determined 
without regard to extensions) for the filing of the return for the 
taxable year in which the sale or exchange occurred.
    (h) Residences acquired in rollovers under section 1034. If a 
taxpayer acquires property in a transaction that qualifies under 
section 1034 (section 1034 property) for the nonrecognition of gain 
realized on the sale or exchange of another property and later sells or 
exchanges such property, in determining the period of the taxpayer's 
ownership and use of the property under section 121 the taxpayer may 
include the periods that the taxpayer owned and used the section 1034 
property as the taxpayer's principal residence (and each prior 
residence taken into account under section 1223(7) in determining the 
holding period of the section 1034 property).
    (i) [Reserved].
    (j) Election to apply regulations retroactively. Taxpayers who 
would otherwise qualify under Sec. Sec.  1.121-1 through 1.121-4 to 
exclude gain from a sale or exchange of a principal residence before 
December 24, 2002 but on or after May 7, 1997, may elect to apply 
Sec. Sec.  1.121-1 through 1.121-4 for any years for which the period 
of limitation under section 6511 has not expired. The taxpayer makes 
the election under this paragraph (j) 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 the provisions 
of these regulations for any years for which the period of limitation 
under section 6511 has not expired by filing an amended return.
    (k) Audit protection. The Internal Revenue Service will not 
challenge a taxpayer's position that a sale or exchange of a principal 
residence occurring before December 24, 2002 but on or after May 7, 
1997, qualifies for the section 121 exclusion if the taxpayer has made 
a reasonable, good faith effort to comply with the requirements of 
section 121. Compliance with the provisions of the regulations project 
under section 121 (REG-105235-99 (2000-2 C.B. 447)) generally will be 
considered a reasonable, good faith effort to comply with the 
requirements of section 121.
    (l) Effective date. This section is applicable for sales and 
exchanges on or after December 24, 2002. For rules on electing to apply 
the provisions retroactively, see paragraph (j) of this section.


Sec.  1.121-5  [Removed]

    Par. 3. Section 1.121-5 is removed.
    Par. 4. Section 1.1398-3 is added to read as follows:


Sec.  1.1398-3  Treatment of section 121 exclusion in individuals' 
title 11 cases.

    (a) Scope. This section applies to cases under chapter 7 or chapter 
11 of title 11 of the United States Code, but only if the debtor is an 
individual.
    (b) Definition and rules of general application. For purposes of 
this section, section 121 exclusion means the exclusion of gain from 
the sale or exchange of a debtor's principal residence available under 
section 121.
    (c) Estate succeeds to exclusion upon commencement of case. The 
bankruptcy estate succeeds to and takes into account the section 121 
exclusion with respect to the property transferred into the estate.
    (d) Effective date. This section is applicable for sales or 
exchanges on or after December 24, 2002.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 11, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 02-32281 Filed 12-23-02; 8:45 am]
BILLING CODE 4830-01-P