[Federal Register Volume 69, Number 157 (Monday, August 16, 2004)]
[Rules and Regulations]
[Pages 50302-50307]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-18714]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9152]
RIN 1545-BB02


Reduced Maximum Exclusion of Gain From Sale or Exchange of 
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. The final regulations apply to 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 
final regulations reflect changes to the law by the Taxpayer Relief Act 
of 1997, as amended by the Internal Revenue Service Restructuring and 
Reform Act of 1998, and the Military Family Tax Relief Act of 2003.

DATES: Effective Date: These final regulations are effective August 13, 
2004.
    Applicability Date: For dates of applicability, see Sec. Sec.  
1.121-3(h) and 1.121-5(e).

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

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1. On December 24, 
2002, the IRS and Treasury Department published in the Federal Register 
a notice of proposed rule making (67 FR 78398) by cross reference to 
temporary regulations (REG-138882-02; 67 FR 78367) under section 121(c) 
of the Internal Revenue Code (Code). The regulations relate 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. Written and electronic comments were received. 
No public hearing was requested or held.
    After considering all of the comments, the proposed regulations are 
adopted as amended by this Treasury decision, and the corresponding 
temporary regulations are removed.

Explanation and Summary of Comments

1. Facts and Circumstances Test

    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 121(c) 
provides that a taxpayer who fails to meet any of the 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.
    The temporary regulations provide, as a general definition, that a 
sale or exchange is by reason of 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 temporary regulations provide factors 
that may be relevant in determining the taxpayer's primary reason for 
the sale or exchange.
    One commentator asserted that the factors are beyond Congressional 
intent, unnecessary, and overbroad. The final regulations retain the 
list of factors because it is helpful in determining the taxpayer's 
primary reason for the sale or exchange.
    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. Under the temporary regulations, if a safe 
harbor applies, the taxpayer's ``primary reason'' for the sale or 
exchange is deemed to be change in place of employment, health, or 
unforeseen circumstances. For greater simplicity, the final regulations 
delete the primary reason test from the safe harbors and provide that, 
if a safe harbor applies, the sale or exchange is deemed to be ``by 
reason of'' a change in place of employment, health, or unforeseen 
circumstances. If a safe harbor does not apply, the taxpayer may be 
eligible to claim a reduced maximum exclusion if the taxpayer 
establishes, based on the facts and circumstances, that the

[[Page 50303]]

taxpayer's primary reason for the sale or exchange is a change in place 
of employment, health, or unforeseen circumstances.

2. 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. One 
commentator asserted that this definition is beyond Congressional 
intent and would allow any circumstance giving rise to the sale or 
exchange of property to qualify for a reduced maximum exclusion.
    The final regulations revise the definition of a sale or exchange 
by reason of unforeseen circumstances from ``an event that the taxpayer 
did not anticipate'' to ``an event that the taxpayer could not 
reasonably have anticipated'' before purchasing and occupying the 
residence. Additionally, the final regulations clarify that a sale or 
exchange by reason of unforeseen circumstances (other than a sale or 
exchange within a safe harbor) does not qualify for the reduced maximum 
exclusion if the primary reason for the sale or exchange is a 
preference for a different residence or an improvement in financial 
circumstances. The final regulations provide additional examples 
illustrating the application of the reduced maximum exclusion rules to 
situations outside of the unforeseen circumstances safe harbors.
    Under the temporary regulations, a taxpayer's primary reason for 
the sale or exchange is deemed to be unforeseen circumstances if one of 
the following safe harbor events occurs during the taxpayer's ownership 
and use of the property: (1) Involuntary conversion of the residence, 
(2) a natural or man made disaster or act of war or terrorism resulting 
in a casualty to the residence, and (3) in the case of a qualified 
individual, (a) death, (b) the cessation of employment as a result of 
which the individual is eligible for unemployment compensation, (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, (d) divorce or legal separation 
under a decree of divorce or separate maintenance, (e) multiple births 
resulting from the same pregnancy, or (f) an event determined by the 
Commissioner to be an unforeseen circumstance. A taxpayer who does not 
qualify for a safe harbor may demonstrate that, under the facts and 
circumstances, the primary reason for the sale or exchange is 
unforeseen circumstances.
    Commentators suggested that marriage, bankruptcy of the taxpayer's 
employer not resulting in the loss of the taxpayer's employment, and 
the adoption of a family member should be additional unforeseen 
circumstances safe harbors that qualify for the reduced maximum 
exclusion.
    The final regulations do not adopt these comments. Marriage and 
adoption are voluntary events that typically lack the degree of 
unforeseeability common in the other unforeseen circumstances safe 
harbors, and bankruptcy of the taxpayer's employer unaccompanied by a 
change in employment status of the taxpayer does not impact the 
taxpayer's current ability to pay housing costs. However, these events 
may still qualify for the reduced maximum exclusion under the facts and 
circumstances test if, as a result of such an event, the taxpayer's 
primary reason for the sale or exchange is a change in place of 
employment, health, or unforeseen circumstances.
    For purposes of the reduced maximum exclusion by reason of 
unforeseen circumstances, the temporary regulations provide that 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.
    A commentator suggested that the unforeseen circumstances exception 
should be limited to events involving only the taxpayer and the 
taxpayer's spouse. The commentator stated that, under this narrower 
exception, a safe harbor for death would be unnecessary because little, 
if any, gain would result as a consequence of the step-up in basis 
provisions of the Code. The commentator also asserted that the safe 
harbor for involuntary conversions is redundant and unnecessary because 
section 1033 already provides for non-recognition of gain in such 
circumstances.
    The final regulations do not adopt these comments. The inclusion in 
the safe harbors of events affecting co-owners and co-inhabitants is 
appropriate because these events may affect the taxpayer's ability to 
pay housing costs. The involuntary conversion safe harbor is also 
appropriate, as both the non-recognition provisions of section 1033 and 
the exclusion provisions of section 121 may apply to a conversion of 
property. See section 121(d)(5).
    The temporary regulations provide that unforeseen circumstances 
include events determined by the Commissioner to be unforeseen 
circumstances to the extent provided in published guidance of general 
applicability or in a ruling directed to a specific taxpayer. The final 
regulations clarify that taxpayers may rely on only those 
determinations made by the Commissioner in published guidance of 
general applicability. A ruling directed to a specific taxpayer does 
not establish a safe harbor of general applicability.

3. Health Exception

    The temporary regulations provide that a sale or exchange of a 
residence 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, 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. This definition is based on the definition of medical care 
under section 213.
    A commentator suggested eliminating the term diagnosis from the 
definition of sale or exchange by reason of health because taxpayers 
rarely would sell a residence merely to obtain a diagnosis of a 
disease, illness, or injury. The final regulations do not adopt this 
suggestion because, while such sales are likely to be uncommon, they 
may occur. In addition, retaining diagnosis in the general definition 
of sale or exchange by reason of health maintains uniformity with the 
definition of medical care under section 213 and reduces complexity.

4. Statute of Limitations

    A commentator suggested that the regulations should clarify that, 
under section 6501, the statute of limitations on assessments arising 
from the use of the exclusion begins to run from the filing date for 
the year of the sale or exchange. The final regulations do not address 
this issue because the issue is well-settled by statute and rules 
regarding the statute of limitations on assessments are outside the 
scope of these regulations.

5. Military Exception

    Numerous commentators suggested that members of the uniformed 
services should be accorded a special exception to the use requirement 
because they are often required to be away from home for extended 
periods of time and unable to use a property as their principal

[[Page 50304]]

residence for at least two years during the five-year period prior to a 
sale or exchange. The final regulations reflect enactment of the 
Military Family Tax Relief Act of 2003 Public Law 108-121, section 101 
(117 Stat. 1335) (MFTRA). The MFTRA amends section 121 to provide that 
a taxpayer serving (or whose spouse is serving) on qualified official 
extended duty as a member of the uniformed services or Foreign Service 
may elect to suspend the running of the 5-year period for up to 10 
years. The election may be made with respect to only one property at a 
time.
    The taxpayer makes an election by filing a return for the taxable 
year of the sale or exchange of the taxpayer's principal residence that 
does not include the resulting gain in the taxpayer's gross income. A 
taxpayer who would qualify to exclude gain under section 121 as a 
result of the amendments made by the MFTRA but is barred by operation 
of any law or rule of law may nonetheless claim a refund or credit of 
an overpayment of tax if the taxpayer files the claim before November 
11, 2004.

6. Effective Dates

    Section 1.121-3 of the final regulations, relating to the reduced 
maximum exclusion, applies to sales and exchanges on or after August 
13, 2004. For sales or exchanges before August 13, 2004 and on or after 
May 7, 1997, taxpayers may elect to apply the rules retroactively in 
accordance with Sec.  1.121-4(j) and will be afforded audit protection 
in accordance with Sec.  1.121-4(k). Section 1.121-5 of the final 
regulations, relating to the suspension of the 5-year period for 
certain members of the uniformed services and Foreign Service, applies 
to sales and exchanges on or after May 7, 1997.

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 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 businesses.

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 Treasury Department participated in 
the development of the regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR Part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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


0
Par. 2. Section 1.121-3 is amended by:
0
1. Adding paragraphs (b), (c), (d), (e), and (f).
0
2. Removing paragraphs (h), (i), (j), and (k).
0
3. Redesignating paragraph (l) as paragraph (h) and revising it.
    The revisions and additions read as follows:


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

* * * * *
    (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. If a safe harbor described in this section 
applies, a sale or exchange is deemed to be by reason of a change in 
place of employment, health, or unforeseen circumstances. If a safe 
harbor described in this section does not apply, 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. 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;
    (2) The suitability of the property as the taxpayer's principal 
residence materially changes;
    (3) The taxpayer's financial ability to maintain the property is 
materially impaired;
    (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. A sale or exchange is deemed to be by 
reason of 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 qualified 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 qualified 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 2003. In 2004 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

[[Page 50305]]

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 2002. In May 
2003 B moves out of his house to take a 3-year assignment in 
Germany. B sells his house in January 2004. 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 2002 that is 35 miles from 
R's Philadelphia office. In May 2003 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 2005 C is assigned to work in R's London 
office. C sells her house in August 2005 as a result of the 
assignment to London. 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 2003 D, who works as an emergency medicine 
physician, buys a condominium that is 5 miles from her place of 
employment and uses it as her principal residence. In February 2004, 
D 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. Because of the demands of the new 
job, 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 an individual is not 
a sale or exchange by reason of health.
    (2) Physician's recommendation safe harbor. A sale or exchange is 
deemed to be by reason of 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 2003 A buys a house that she uses as her principal 
residence. A is injured in an accident and is unable to care for 
herself. A sells her house in 2004 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 2003 H and W 
purchase a house that they use as their principal residence. In 2004 
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 2003 that they use as 
their principal residence. Their son suffers from a chronic illness 
that requires regular medical care. Later that year their son begins 
a new treatment that is available at a hospital 100 miles away from 
their residence. In 2004 H and W sell their house so that they can 
be closer to the hospital to facilitate their son's treatment. 
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 2003 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 2004 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 2003 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 outdoor exercise, but H is not suffering from any 
disease that can be treated or mitigated by outdoor exercise. In 
2004 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 
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 could not reasonably have anticipated before 
purchasing and occupying the residence. A sale or exchange by reason of 
unforeseen circumstances (other than a sale or exchange deemed to be by 
reason of unforeseen circumstances under paragraph (e)(2) or (3) of 
this section) does not qualify for the reduced maximum exclusion if the 
primary reason for the sale or exchange is a preference for a different 
residence or an improvement in financial circumstances.
    (2) Specific event safe harbors. A sale or exchange is deemed to be 
by reason of 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 qualified 
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.
    (3) Designation of additional events as unforeseen circumstances. 
The Commissioner may designate other events or situations as unforeseen 
circumstances in published guidance of general applicability and may 
issue

[[Page 50306]]

rulings addressed to specific taxpayers identifying other events or 
situations as unforeseen circumstances with regard to those taxpayers 
(see Sec.  601.601(d)(2) of this chapter).
    (4) 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 and reasonable basic living 
expenses for their household 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. In 2003 B buys a condominium in a high-rise building 
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 replaces the building's roof and heating 
system. Six months later, B's monthly condominium fee doubles in 
order to pay for the repairs. B sells the condominium in 2004 
because he is unable to afford the new condominium fee along with a 
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, the doubling of the 
condominium fee, is an unforeseen circumstance because B could not 
reasonably have anticipated that the condominium fee would double at 
the time he purchased and occupied the property. Consequently, the 
sale of the condominium is by reason of 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 traveled road. C 
sells the property in 2004 because C is disturbed by the traffic. 
The safe harbors of paragraph (e)(2) of this section do not apply. 
Under the facts and circumstances, the primary reason for the sale, 
the traffic, is not an unforeseen circumstance because C could 
reasonably have anticipated the traffic at the time he purchased and 
occupied the house. Consequently, the sale of the house is not by 
reason of unforeseen circumstances and C is not entitled to claim a 
reduced maximum exclusion under section 121(c)(2).
    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, the broken engagement, is an unforeseen circumstance 
because D and E could not reasonably have anticipated the broken 
engagement at the time they purchased and occupied the house. 
Consequently, the sale is by reason of unforeseen circumstances and 
D and E are each entitled to claim a reduced maximum exclusion under 
section 121(c)(2).
    Example 7. In 2003 F buys a small condominium that she uses as 
her principal residence. In 2005 F receives a promotion and a large 
increase in her salary. F sells the condominium in 2004 and 
purchases a house because she can now afford the house. The safe 
harbors of paragraph (e)(2) of this section do not apply. Under the 
facts and circumstances, the primary reason for the sale of the 
house, F's salary increase, is an improvement in F's financial 
circumstances. Under paragraph (e)(1) of this section, an 
improvement in financial circumstances, even if the result of 
unforeseen circumstances, does not qualify for the reduced maximum 
exclusion by reason of unforeseen circumstances under section 
121(c)(2).
    Example 8. In April 2003 G buys a house that he uses as his 
principal residence. G sells his house in October 2004 because the 
house has greatly appreciated in value, mortgage rates have 
substantially decreased, and G can afford a bigger house. The safe 
harbors of paragraph (e)(2) of this section do not apply. Under the 
facts and circumstances, the primary reasons for the sale of the 
house, the changes in G's house value and in the mortgage rates, are 
an improvement in G's financial circumstances. Under paragraph 
(e)(1) of this section, an improvement in financial circumstances, 
even if the result of unforeseen circumstances, does not qualify for 
the reduced maximum exclusion by reason of unforeseen circumstances 
under section 121(c)(2).
    Example 9. H works as a police officer for City X. In 2003 H 
buys a condominium that he uses as his principal residence. In 2004 
H is assigned to City X's K-9 unit and is required to care for the 
police service dog at his home. Because H's condominium association 
does not permit H to have a dog in his condominium, in 2004 he sells 
the condominium and buys a house. 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, H's assignment to 
the K-9 unit, is an unforeseen circumstance because H could not 
reasonably have anticipated his assignment to the K-9 unit at the 
time he purchased and occupied the condominium. Consequently, the 
sale of the condominium is by reason of unforeseen circumstances and 
H is entitled to claim a reduced maximum exclusion under section 
121(c)(2).
    Example 10. In 2003, J buys a small house that she uses as her 
principal residence. After J wins the lottery, she sells the small 
house in 2004 and buys a bigger, more expensive house. The safe 
harbors of paragraph (e)(2) of this section do not apply. Under the 
facts and circumstances, the primary reason for the sale of the 
house, winning the lottery, is an improvement in J's financial 
circumstances. Under paragraph (e)(1) of this section, an 
improvement in financial circumstances, even if the result of 
unforeseen circumstances, does not qualify for the 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.
* * * * *
    (h) Effective dates. Paragraphs (a) and (g) of this section are 
applicable for sales and exchanges on or after December 24, 2002. 
Paragraphs (b) through (f) of this section are applicable for sales and 
exchanges on or after August 13, 2004.


Sec.  1.121-3T  [Removed]

0
Par. 3. Section 1.121-3T is removed.

0
Par. 4. Section 1.121-5 is added to read as follows:


Sec.  1.121-5  Suspension of 5-year period for certain members of the 
uniformed services and Foreign Service.

    (a) In general. Under section 121(d)(9), a taxpayer who is serving 
(or whose spouse is serving) on qualified official extended duty as a 
member of the uniformed services or Foreign Service of the United 
States may elect to suspend the running of the 5-year period of 
ownership and use during such service but for not more than 10 years. 
The election does not suspend the running of the 5-year period for any 
period during which the running of the 5-year period with respect to 
any other property of the taxpayer is suspended by an election under 
section 121(d)(9).
    (b) Manner of making election. The taxpayer makes the election 
under section 121(d)(9) and this section by filing a return for the 
taxable year of the

[[Page 50307]]

sale or exchange of the taxpayer's principal residence that does not 
include the gain in the taxpayer's gross income.
    (c) Application of election to closed years. A taxpayer 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 on or after May 
7, 1997, may elect to apply section 121(d)(9) and this section for any 
years for which a claim for refund is barred by operation of any law or 
rule of law by filing an amended return before November 11, 2004.
    (d) Example. The provisions of this section are illustrated by the 
following example:

    Example. B purchases a house in Virginia in 2003 that he uses as 
his principal residence for 3 years. For 8 years, from 2006 through 
2014, B serves on qualified official extended duty as a member of 
the Foreign Service of the United States in Brazil. In 2015 B sells 
the house. B did not use the house as his principal residence for 2 
of the 5 years preceding the sale. Under section 121(d)(9)and this 
section, however, B may elect to suspend the running of the 5-year 
period of ownership and use during his 8-year period of service with 
the Foreign Service in Brazil. If B makes the election, the 8-year 
period is not counted in determining whether B used the house for 2 
of the 5 years preceding the sale. Therefore, B may exclude the gain 
from the sale of the house under section 121.

    (e) Effective date. This section is applicable for sales and 
exchanges on or after May 7, 1997.

Nancy Jardini,
Acting Deputy Commissioner for Services and Enforcement.
    Approved: July 29, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-18714 Filed 8-13-04; 8:45 am]
BILLING CODE 4830-01-P