[Federal Register Volume 65, Number 196 (Tuesday, October 10, 2000)]
[Proposed Rules]
[Pages 60136-60141]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-25482]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105235-99]
RIN 1545-AX28


Exclusion of Gain From Sale or Exchange of a Principal Residence

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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

SUMMARY: This document contains proposed regulations relating to the 
exclusion of gain from the sale or exchange of a taxpayer's principal 
residence. These proposed 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. These proposed 
regulations generally affect taxpayers who sell or exchange their 
principal residences.

DATES: Written or electronically generated comments must be received by 
January 8, 2001. Requests to speak (with outlines of oral comments) to 
be discussed at the public hearing scheduled for January 23, 2001 at 10 
a.m., must be submitted by January 3, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-105235-99), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:M&SP:RU (REG- 105235-99), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Ave., NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically via the 
Internet by selecting the ``Tax Regs'' option on the IRS Home Page, or 
by submitting comments directly to the IRS internet site at http://www.irs.gov/tax_regs/regslist.html. The public hearing will be held in 
the IRS Auditorium, Seventh Floor, Internal Revenue Service Building, 
1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Sara P. 
Shepherd, (202) 622-4910; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, contact Treena Garrett, (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

1. Section 121  Exclusion

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 121 of the Internal Revenue 
Code relating to the exclusion of gain from the sale or exchange of a 
taxpayer's principal residence. These proposed regulations reflect 
changes to the law made by the Taxpayer Relief Act of 1997, Public Law 
105-34 (111 Stat. 788 (TRA 1997)), as amended by the Internal Revenue 
Service Restructuring and Reform Act of 1998, Public Law 105-206 (112 
Stat. 805 (RRA 1998)).
    Prior to the repeal by TRA 1997, section 1034 provided that gain 
from the sale or exchange of a principal residence (old residence) was 
recognized only to the extent that the taxpayer's adjusted sales price 
of the old residence exceeded the taxpayer's cost of purchasing a new 
residence within the replacement period (generally 2 years before or 
after the date of sale).
    Prior to amendment by TRA 1997, former section 121 provided that a 
taxpayer could make a one-time election to exclude up to $125,000 of 
gain from the sale or exchange of property. To qualify for the 
exclusion, the taxpayer must have: (1) Been age 55 or older on the date 
of the sale or exchange; and (2) owned and used the property as the 
taxpayer's principal residence for at least 3 years during the 5-year 
period ending on the date of the sale or exchange.
    TRA 1997 amended section 121 and repealed section 1034 for sales 
and exchanges of principal residences after May 6, 1997 (except, at the 
election of the taxpayer, to a sale or exchange: (1) Made on or before 
August 5, 1997; (2) made pursuant to a binding contract in effect on 
August 5, 1997; or (3) that would qualify under section 1034 by reason 
of a new residence acquired on or before August 5, 1997 or pursuant to 
a binding contract in effect on August 5, 1997). Under section 121 as 
amended, a taxpayer generally excludes up to $250,000 ($500,000 for 
certain joint returns) of gain realized on the sale or exchange of 
property if the property was owned and used as the taxpayer's principal 
residence for at least 2 years during the 5-year period ending on the 
date of the sale or exchange. The exclusion applies regardless of the 
age of the taxpayer, and the full exclusion can be used only once every 
2 years. A taxpayer who fails to meet these requirements by reason of a 
change in place of employment, health, or, to the extent provided in 
regulations, unforeseen circumstances may be entitled to a reduced 
exclusion.
    RRA 1998 amended TRA 1997 to clarify that the reduced exclusion 
amount under section 121(c) is a portion of the maximum limitation 
amount ($250,000 or $500,000 for certain joint returns), not a portion 
of the realized gain. See H.R. Rep. No. 356, 105th Cong., 1st Sess. 17 
(1997); S. Rep. No. 174, 105th Cong., 2d Sess. 150 (1998). In addition, 
the amendments provided that for married taxpayers filing jointly but 
failing to meet the ownership, use, or timing requirements of section 
121(b)(2)(A), the maximum limitation amount will be the sum of each 
spouse's limitation amount determined on a separate basis as if they 
had not been married. S. Rep. No. 174, 105th Cong., 2d Sess. 151 
(1998); H.R. Conf. Rep. No. 599, 105th Cong., 2d Sess. 337 (1998). 
Lastly, the amendments clarified that a taxpayer may elect to apply 
prior law under section 1034 or former section 121 to a sale or 
exchange occurring on as well as before the date of enactment, August 
5, 1997. H.R. Rep. No. 356, 105th Cong., 1st Sess. 18 (1997); S. Rep. 
No. 174, 105th Cong., 2d Sess. 151 (1998).

2. Section 121  Exclusion in Individuals' Title 11 Cases

    This document also contains proposed amendments to the Income 
Taxation Regulations (26 CFR part 1) under section 1398 of the Internal 
Revenue Code. Under the authority provided in section 1398(g)(8), the 
regulations add the section 121 exclusion to the list of tax attributes 
of the debtor 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 in computing the taxable income of 
the estate. Although these regulations are proposed to be applicable on 
or after the date they are published as 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), AOD CC-1999-
009 (August 30, 1999), and Chief Counsel Notice (35)000-162 (August 10, 
1999), the IRS will not challenge the position taken prior to the 
effective date of these regulations that a bankruptcy estate may use 
the section 121 exclusion if the

[[Page 60137]]

debtor would otherwise satisfy the section 121 requirements.

Explanation of Provisions

1. Section 121  Exclusion

    Section 1.121-1(b) of the proposed regulations addresses the 
definition of principal residence. This section provides that whether 
or not property is the taxpayer's principal residence, and whether or 
not property is used by the taxpayer as the taxpayer's principal 
residence (in the case of a taxpayer using more than one property as a 
residence), depends upon all the facts and circumstances. If a taxpayer 
alternates between two 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 will ordinarily be considered the 
taxpayer's principal residence.
    Section 1.121-1(c) of the proposed regulations addresses the use 
requirement under section 121(a). This section provides that, in order 
for a taxpayer to satisfy the use requirement under section 121(a), the 
taxpayer must occupy the residence (except for short temporary 
absences) for at least 2 years during the 5-year period ending on the 
date of the sale or exchange. See H.R. Rep. No. 148, 105th Cong., 1st 
Sess. at 348 (1997); S. Rep. No. 33, 105th Cong., 1st Sess. at 37 
(1997); H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. at 386 (1997).
    Section 1.121-1(d) provides that 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 periods after May 6, 1997, in 
respect of the property.
    Section 1.121-1(e) of the proposed regulations provides that if a 
taxpayer satisfies the use requirement only with respect to a portion 
of the property sold or exchanged, section 121 will apply only to the 
gain from the sale or exchange allocable to that portion. Thus, if the 
residence was used partially for residential purposes and partially for 
business purposes, only that part of the gain allocable to the 
residential portion is excludable under section 121. Furthermore, the 
section 121 exclusion does not apply to the extent that depreciation 
attributable to periods after May 6, 1997, exceeds gain allocable to 
the business-use portion of the property.
    Under section 121(c), a reduced exclusion is 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 section 121(a) or the 2-year limitation 
described in section 121(b)(3). Section 1.121-3(a)(1) of the proposed 
regulations provides that the reduced exclusion applies only if the 
sale or exchange is necessitated by a change in place of employment, 
health, or, to the extent provided in forms, instructions, or other 
appropriate guidance including regulations and letter rulings, 
unforeseen circumstances. The IRS and the Treasury Department request 
written comments regarding what should qualify as an unforeseen 
circumstance for purposes of determining whether a taxpayer is eligible 
to claim the reduced exclusion available under section 121(c).
    Under section 121(d)(8), a taxpayer must make an election to have 
the section 121 exclusion apply to a sale or exchange of a remainder 
interest in the taxpayer's principal residence. Section 1.121-4(f)(3) 
provides that the taxpayer makes 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 remainder interest in the taxpayer's 
gross income.
    Under section 121(f), a taxpayer must make an election to have the 
section 121 exclusion not apply to a sale or exchange of the taxpayer's 
principal residence. Section 1.121-4(h) provides that 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 
residence in the taxpayer's gross income.

2. Section 121  Exclusion in Individuals' Title 11 Cases

    Section 1.1398-3 of the proposed regulations provides 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 debtor's section 121 exclusion if the taxpayer satisfies 
the requirements of section 121.

3. Proposed Effective Date

    These regulations are proposed to be applicable for sales or 
exchanges that occur on or after the date they are published as final 
regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking 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, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies of written comments) that are 
submitted timely (in the manner described in the ADDRESSES caption) to 
the IRS. The IRS and Treasury request comments on the clarity of the 
proposed rules and how they may be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 23, 2001, beginning 
at 10 a.m. in the IRS Auditorium, Seventh Floor, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to 
building security procedures, visitors must enter at the 10th Street 
entrance, located between Constitution and Pennsylvania Avenues, NW. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 15 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of the preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by 
January 3, 2001. A period of 10 minutes will be allotted to each person 
making comments. An agenda showing the scheduling of the speakers will 
be prepared after the deadline for receiving outlines has passed. 
Copies of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Sara P. Shepherd, 
Office of Assistant Chief Counsel (Income Tax and Accounting). However, 
other personnel from the IRS and the Treasury

[[Page 60138]]

Department participated in the development of the regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be 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 
section 121, a taxpayer will 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) Principal residence. Whether or not property is used by the 
taxpayer as the taxpayer's residence, and whether or not property is 
used by the taxpayer as the taxpayer's principal residence (in the case 
of a taxpayer using more than one property as a residence), depends 
upon all the facts and circumstances. If a taxpayer alternates between 
two 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 will ordinarily be considered the taxpayer's principal 
residence. A property used by the taxpayer as the taxpayer's principal 
residence may include a houseboat, a house trailer, or stock held by a 
tenant-stockholder in a cooperative housing corporation (as those terms 
are defined in section 216(b)(1) and (2)), if the dwelling that the 
taxpayer is entitled to occupy as a stockholder is used by the taxpayer 
as the taxpayer's principal residence. Property used by the taxpayer as 
the taxpayer's principal residence does not include personal property, 
that is not a fixture under local law.
    (c) Ownership and use requirements. 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. In 
establishing whether a taxpayer has satisfied the 2-year use 
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.
    (d) Depreciation taken after May 6, 1997. 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 periods after May 6, 
1997, in respect of the property.
    (e) Property used in part as a principal residence. If a taxpayer 
satisfies the use requirement only with respect to a portion of the 
property sold or exchanged, section 121 will apply only to the gain 
from the sale or exchange allocable to that portion. Thus, if the 
residence was used partially for residential purposes and partially for 
business purposes, only that part of the gain allocable to the 
residential portion is excludable under section 121. Furthermore, the 
section 121 exclusion does not apply to the extent that depreciation 
attributable to periods after May 6, 1997, exceeds gain allocable to 
the business-use portion of the property. See Example 8 in paragraph 
(f) of this section.
    (f) Examples. The provisions of paragraphs (a) through (e) of this 
section are illustrated by the following examples:

    Example 1. Taxpayer A has owned and used his house as his 
principal residence since 1986. On January 1, 1998, A moves to 
another state. A leases his house 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 years out of the 5 years preceding the sale.
    Example 2. Taxpayer B owned and used a house as her principal 
residence from 1986 to the end of 1997. On January 1, 1998, B moved 
to another state and ceases to use the house. B's move was not 
necessitated by a change in place of employment, health, or 
unforeseen circumstances. B's son moved into the house in March 1999 
and used the residence until it was sold on July 1, 2001. Taxpayer 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 lived in a townhouse that he rented from 
1993 through 1997. On January 1, 1998, he purchased this townhouse. 
On February 1, 1998, C moved into his daughter's home. On March 1, 
2000, while still living in his daughter's home, C sold 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 1, 1998 until March 1, 2000) 
and he used the townhouse as his principal residence for at least 2 
years during the 5-year period preceding the sale (from March 1, 
1995 until February 1, 1998).
    Example 4. Taxpayer D, a college professor, purchased and moved 
into a house on May 1, 1997. He used the house as his principal 
residence continuously until September 1, 1998, when he went abroad 
for a 1-year sabbatical leave. On October 1, 1999, 1 month after 
returning from the leave, D sold the house. Because his leave is not 
considered to be a short temporary absence for purposes of section 
121 (see paragraph (c) of this section), the period of the 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 purchased a house on February 1, 1998, 
that he used as his principal residence. During 1998 and 1999, E 
left his residence for a 2-month summer vacation. E sold 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 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.
    Example 6. On July 1, 1999, Taxpayer F moves into a house that 
he owns and had rented to tenants since July 1, 1997. F 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, F sells the property on August 1, 2001. 
F's gain realized from the sale is $40,000. F had no capital losses 
for 2001. Only $26,000 ($40,000 gain realized--$14,000 depreciation 
deductions) may be excluded under section 121. The $14,000 of gain 
recognized by F is unrecaptured section 1250 gain within the meaning 
of section 1(h).
    Example 7. Taxpayer G, an attorney, uses a portion of her 
principal residence as a law office for a period in excess of 3 
years out of the 5 years preceding the sale of the property. Because 
G did not use the law office portion of the property as her 
residence, the section 121 exclusion does not apply to the gain from 
the sale that is allocable to the law office portion of the 
property.
    Example 8. Taxpayer H buys a house in 1998. For 5 years, H uses 
a portion of the property as his principal residence and a

[[Page 60139]]

portion of the property for business purposes. H claims depreciation 
deductions of $20,000 for the business use of the property. H sells 
the property in 2003, realizing a gain of $50,000. H had no other 
section 1231 or capital gains or losses for 2003. H determines that 
$15,000 of the gain is allocable to the business-use portion of the 
property and that $35,000 of the gain is allocable to the portion of 
the property used as his residence. H must recognize $15,000 of the 
gain allocable to the business-use portion of the property. This 
$15,000 of gain is unrecaptured section 1250 gain within the meaning 
of section 1(h). In addition, the section 121 exclusion does not 
apply to the extent that H's post-May 6, 1997 depreciation ($20,000) 
exceeds the gain allocable to the business-use portion of the 
property ($15,000). Therefore, H may exclude $30,000 of the gain 
from the sale of the property. The remaining $5,000 of gain is 
recognized by H as unrecaptured section 1250 gain within the meaning 
of section 1(h).
    Example 9. Taxpayer J buys a house in 1998. For 5 years, J uses 
a portion of the property as her principal residence and a portion 
of the property for business purposes. J claims depreciation 
deductions of $10,000 for the business use of the property. J sells 
the property in 2003, realizing a gain of $50,000. J had no other 
section 1231 or capital gains or losses for 2003. J determines that 
$15,000 of the gain is allocable to the business-use portion of the 
property and that $35,000 of the gain is allocable to the portion of 
the property used as her residence. J must recognize the $15,000 of 
gain allocable to the business-use portion of the property ($10,000 
of which is unrecaptured section 1250 gain within the meaning of 
section 1(h), and $5,000 of which adjusted net capital gain). J may 
exclude $35,000 of the gain from the sale of the property.
    Example 10. Taxpayer K owns two residences, one in New York and 
one in Florida. From 1999 through 2003, K lives in the New York 
residence for 7 months and the Florida residence for 5 months. Thus, 
K used the New York residence a majority of the time in each year 
from 1999 through 2003. Therefore, in the absence of facts and 
circumstances indicating otherwise, the New York residence is K's 
principal residence, and only the New York residence would be 
eligible for the 121 exclusion if it were sold at the end of 2003.
    Example 11. Taxpayer L owns two residences, one in Virginia and 
one in Maine. During 1999 and 2000, L lives in the Virginia 
residence. During 2001 and 2002, L lives in the Maine residence. 
During 2003, L lives in the Virginia residence. L's principal 
residence during 1999, 2000, and 2003 is the Virginia residence. L's 
principal residence during 2001 and 2002 is the Maine residence. 
Either residence would be eligible for the 121 exclusion if it were 
sold during 2003.

    (g) Effective date. This section and Secs. 1.121-2 through 1.121-4 
are applicable for sales and exchanges that occur on or after the date 
these regulations are published as final regulations in the Federal 
Register.


Sec. 1.121-2  Limitations.

    (a) Dollar limitations. A taxpayer may exclude from gross income up 
to $250,000 of gain from the sale or exchange of the taxpayer's 
principal residence. If taxpayers jointly own a principal residence but 
file separate returns, each taxpayer will 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.
    (b) Special rules for joint returns--(1) In general. A husband and 
wife who make a joint return for the year of the sale or exchange may 
exclude up to $500,000 of gain if--
    (i) Either spouse meets the 2-year ownership requirements of
    Sec. 1.121-1(a);
    (ii) Both spouses meet the 2-year use requirements of Sec. 1.121-
1(a); and
    (iii) Neither spouse excluded gain from a prior sale or exchange of 
property under section 121 within the last 2 years (as determined under 
paragraph (c) of this section).
    (2) Other joint returns. For taxpayers filing jointly, if the 
spouses fail to meet the requirements of paragraph (b)(1) of this 
section, the maximum limitation amount to be claimed by the couple will 
be 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 will be treated as owning the 
property during the period that either spouse owned the property.
    (3) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1. Married taxpayers H and W sell their residence and 
the gain realized from the sale is $256,000. A and B meet the 
requirements of section 121 and file a joint return for the year of 
the sale. The entire amount of gain from the sale of their principal 
residence is excluded from gross income because the gain realized 
from the sale does not exceed the limitation amount of $500,000 
available to taxpayers filing a joint return.
    Example 2. 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 eligible to exclude up to $250,000 of gain from the sale 
of each of their residences. However, W may not use H's unused 
exclusion to exclude gain in excess of her exclusion amount. 
Therefore, H and W must recognize $50,000 of the gain realized on 
the sale of W's residence.
    Example 3. Married taxpayers H and W sell their residence and 
file a joint return for the year of the sale. Section 1.121-3 
(relating to the reduced exclusion) does not apply to the sale of 
their residence. 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 4. Married taxpayers H and W have owned and used their 
principal residence since 1998. On February 16, 2001, H dies. On 
September 21, 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 may be excluded.
    Example 5. Assume the same facts as Example 4 except that W does 
not sell the residence until January 15, 2002. Because W's filing 
status for the taxable year of the sale is single, the special rules 
for joint returns under paragraph (b) of this section do not apply 
and W may exclude only $250,000 of the gain.

    (c) 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 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 (c)(1), 
any sale or exchange before May 7, 1997 is disregarded.
    (2) Example. The following example illustrates the rules of this 
paragraph (c):

    Example. Taxpayer A owned a townhouse that he used as his 
principal residence for two full years, 1998 and 1999. A then bought 
a house in 2000 that he owned and used 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 the next year, 2003. Section 
1.121-3 (relating to the reduced exclusion) does not apply to the 
sale of the house. 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.


Sec. 1.121-3  Reduced exclusion.

    (a) Reduced exclusion for taxpayers failing to meet certain 
requirements; in general. A reduced exclusion is 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)

[[Page 60140]]

or the 2-year limitation described in Sec. 1.121-2(c). This reduced 
exclusion applies only if the sale or exchange is necessitated by a 
change in place of employment, health, or, to the extent provided in 
forms, instructions, or other appropriate guidance including 
regulations and letter rulings, unforeseen circumstances. The reduced 
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 as the taxpayer's principal residence 
during the 5-year period ending on the date of the sale or exchange; 
the period of time that the taxpayer used the property 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).
    (b) Examples. The following examples illustrate the rules of this 
section:

    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 owned a house that he 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 H's and 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 both 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(b)(2).)
    (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, W is eligible to 
claim a reduced exclusion. Because the sale of the house is due to a 
change in place of employment, W is eligible to exclude 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 <SUP>+</SUP> 
$125,000) from the sale of the house.


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:

    Example. Taxpayer H has owned and used a house as his principal 
residence since January 1, 1987. H and W marry on January 1, 1999 
and from that date they use H's house as their principal residence. 
H dies on January 15, 2000, and W inherits the property and 
continues to use the property as her principal residence. W sells 
the property on August 31, 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 a 
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 section 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 was 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 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 that had 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 paid A $400,000 for the house. 
Thus, A realized 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.


[[Page 60141]]


    (e) 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 a period 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.
    (f) Sales of remainder interests--(1) In general. A taxpayer may 
elect to have the section 121 exclusion apply to gain from the sale or 
exchange of a remainder interest in the taxpayer's principal residence.
    (2) Limitations--(i) 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.
    (ii) Sales to related parties. Paragraph (f)(1) of this section 
will not apply to a sale or exchange by any person who bears a 
relationship to the taxpayer which is described in section 267(b) or 
707(b).
    (3) Election. The taxpayer makes the election under this paragraph 
(f) 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.
    (g) No exclusion for expatriates. The section 121 exclusion will 
not apply to any sale or exchange by an individual if the treatment 
provided by section 877(a)(1) (relating to the treatment of 
expatriates) applies to the individual.
    (h) 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.
    (i) Residences acquired in rollovers under section 1034. If a 
taxpayer acquires property (section 121 property) in a transaction that 
qualifies under section 1034 for the nonrecognition of gain realized on 
the sale or exchange of another property (section 1034 property) and 
later sells or exchanges the section 121 property, in determining the 
period of the taxpayer's ownership and use of the sold or exchanged 
section 121 property, 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 1034 
property).


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 that occur on or after the date these regulations are 
published as final regulations in the Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 00-25482 Filed 10-6-00; 8:45 am]
BILLING CODE 4830-01-U