Question: You have written that if we live in our house for two out of the last five years before it is sold, we can exclude up to $500,000 of profit if we are married and file a joint income tax return (or up to $250,000 if we file a single tax return). My husband and I have lived in our house for almost one year, and he is being transferred to Ohio. We have to sell our house and will make a considerable profit. Do we have to pay capital gains tax on the full profit because we have not lived there for the full two years?

Answer: In your case, you will be able to exclude a portion of your gain. The IRS calls this a "reduced maximum exclusion."

The law (section 121c of the Internal Revenue Code) does allow partial exclusions of gain where "such sale ... is by reason of a change in place of employment, health, or to the extent provided in regulations, unforeseen circumstances."

On December 24, 2002, the Internal Revenue Service issued temporary regulations which attempted to clarify and interpret the language of the code. Let's look at the three basic requirements:

Change in place of employment: If the taxpayer's new place of employment is at least 50 miles farther from the principal residence than was the former place of employment, the IRS considers this to be a "safe harbor." This means that you will qualify for the reduced (partial) exclusion of gain. Additionally, if the taxpayer was previously unemployed and the distance between the new place of employment and the residence which was sold is at least 50 miles, this will also qualify for the partial exclusion.

Sale by reason of health: If the primary reason for selling the family home is to "obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness or injury," then once again the IRS will permit a partial exclusion for gain should the home be sold before the taxpayer has lived and owned the property for two full years. It should be noted that the health problem can be that of the taxpayer, the taxpayer's spouse, or even the grandparents of the taxpayer. To be on the safe side -- and to get the benefits of the "safe harbor" -- it is advisable to obtain a physician's written recommendation for this change of residence.

Sale by reason of unforeseen circumstances: This is a catch-all, created by Congress to ensure that taxpayers will not lose the partial exclusion if "the primary reason for the sale ... is the occurrence of an event that the taxpayer does not anticipate before purchasing and occupying the residence."

Under this category, the IRS has announced several "safe harbors," such as natural or man-made disasters or acts of war or terrorism, death of the taxpayer, divorce or legal separation, and even multiple births resulting from the same pregnancy.

Additionally, according to the temporary regulations, the IRS can make a determination on a case by case basis as to whether a particular set of facts would qualify under the category of "unforeseen circumstances."

Indeed, in September of 2003, the IRS addressed a unique set of facts, and ruled that they did qualify for the partial exclusion. Here are the facts: A, a family member and inhabitant of taxpayer's house, was convicted of a crime, placed on probation and spent one year at a rehabilitation facility. While A was in rehab, the taxpayer bought a new house, which became their principal residence. According to the facts, when the house was purchased, the taxpayer expected that A would not be living there on a permanent basis.

However, after one year, the Court ordered A to live at the house under house arrest and to continue receiving rehabilitation counseling. Unfortunately, the neighbors began to vehemently protest A's presence in the neighborhood, and even interfered with A's efforts to find gainful employment. A's probation office recommended that the house be sold, so that the family could move to another neighborhood.

Taxpayer sold the house, and did not live or own it for a full two-year period.

Based on these facts, the IRS concluded that the primary reason for the sale of the house was, in fact, an "unforeseen circumstance," and allowed the taxpayer to exclude gain up to the "reduced maximum exclusion" amount. (IRS Private Letter Ruling, 200403049) It is to be noted that such private letter rulings are only binding on the specific taxpayer who requested the ruling, and may not be cited as precedent for other such tax cases. Nevertheless, it does indicate the thinking process of the IRS.

Now that we have explored the various ways in which the taxpayer can obtain a partial exclusion of gain, let's look to the formula for calculating such exclusion. According to the IRS:

The reduced maximum exclusion is computed by multiplying the maximum dollar limitation of $250,000 (or $500,000 for certain joint filers) by a fraction.

The numerator is the period of time in which the taxpayer owned the property, and the denominator is 730 days or 24 months, depending on the measure of time used in the numerator. For those not skilled in math, let's look at this example:

Mr. and Mrs. A buy their house on January 1, 2003. On February 1, 2004 (13 months later) based on a change of employment over 50 miles away from their principal house, they sell the house. Because they are married and file a joint tax return, the formula is: $500,000 x 13/24 = $270,833.33. In other words, if Mr. and Mrs. A have been fortunate enough to make a large profit in the 13 months in which they owned their house, they are able to exclude up to $270,833.33 of any profit.

This partial exclusion is not complex, but if you have to sell your house before two years of ownership, make sure that you can fit into one of the "safe harbors." Otherwise, you will have to pay the 15 percent capital gains federal tax and any applicable state and local income tax.