Adoption Requirements Qualified as Unforeseen Circumstances for Principal Residence Exclusion

In a recent ruling, a taxpayer qualified for a reduced principal residence exclusion when she sold a principal residence less than two years after purchasing it so that she could meet state adoption requirements.

Facts

After purchasing and moving into her principal residence with her sons, Y decided to adopt an orphan girl from a foreign country. However, under state law, she could not adopt a girl unless she had a separate sizable bedroom. Thus, Y could not pass the home study at the principal residence (the first step toward adoption) because she could not provide a girl with a separate bedroom.

Y was also informed that once the home study begins, all information has to be consistent throughout the entire adoption process, or the home study inspections and reviews would have to be completely redone. Further, Y is currently in the military and was scheduled to be transferred to a new post of duty in the summer or the fall. Thus, Y had to start and complete the adoption process before the transfer; if not, the entire adoption process must start over.

Accordingly, Y decided to rent a larger home with an additional room in which a girl could have her own bedroom. She sold the principal residence, which she had used and owned as a principal residence for less than two years, and moved into the rented residence. Y used the rented residence to provide the required information for the home study.

Analysis

Under Sec. 121(a), gross income does not include gain from the sale or exchange of a residence if, during the five-year period ending on the date of the sale or exchange, the taxpayer has owned and used the residence as a principal residence for periods aggregating two years or more. The full exclusion is available only once every two years (Sec. 121(b)(3)).

The maximum exclusion amount is $500,000 if (1) a husband and wife file a joint return for the tax year of the sale, (2) both spouses meet the two-year use test, (3) at least one of the spouses meets the two-year ownership test and (4) neither spouse used the Sec. 121 exclusion during the last two years.

Under an exception in Sec.121(c), taxpayers who fail to satisfy the ownership and use tests or the limit of one sale every two years may qualify for a reduced maximum exclusion if the primary reason for a sale or exchange is a change in place of employment, health or unforeseen circumstances. A sale or exchange is due to unforeseen circumstances if the primary reason for it is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence; see Regs. Sec. 1.121-3(e)(1).

Conclusion

The IRS concluded that Y’s primary reason for the sale was an unforeseen circumstance (i.e., she would need another residence to qualify for an impending adoption). Accordingly, Y was entitled to exclude gain up to the reduced maximum exclusion amount under Sec. 121(c).

IRS Letter Ruling 200613009 (3/31/06)

Reflections: In IRS Letter Ruling 200601022 (1/6/06), a taxpayer qualified for the reduced exclusion when, after purchasing the principal residence, she remarried and the family temporarily moved to her  spouse’s school district so that his child could attend school there. After moving, the taxpayer initially rented out the former principal residence, but sold it when she had another child because it was too small for the family.