The 1997 Tax Act eliminated the rollover gain provision as well as the one-time $125,000 exclusion for persons 55 years or older. IRC § 121 now provides for an exclusion of $250,000 which may be claimed every 2 years. To qualify, the taxpayer must own and use the principal residence for 2 of 5 years prior to the sale date.

The following rules ease compliance: (i) the ownership and use tests may be satisfied at different times during the 5-year period; (ii) aggregation of noncontinuous periods is permitted in satisfying the use test; (iii) short absences (e.g., vacation or rental) are ignored; and (iv) residence at the home on the sale date is not required.

A partial exclusion for a sale occurring prior to 2 years may be claimed if the sale was precipitated by a change in place of employment, health reasons or “unforeseen circumstances” as articulated in the (as yet unpromulgated) regulations. The partial exemption is based on the portion of the two-year period in which the taxpayer satisfies the ownership and use tests. Thus, a taxpayer forced to sell after a year would be entitled to ½ of a full $250,000 exclusion.

An exclusion of $500,000 is available to joint filers with respect to a particular residence if (i) both spouses meet the use test; (ii) either meets the ownership test; and (iii) neither has claimed an exclusion within the last 2 years. However, if joint filers cannot meet this test, each spouse may still be entitled to claim a separate $250,000 exclusion on the joint return. In so determining, each spouse is treated as owning the property during the period that either spouse owned the property, and each spouse’s exclusion is computed as if the spouses were unmarried. This mechanism eliminates the “taint” which occurred under the previous law when one spouse had claimed the exemption prior to marriage.

Liberal rules apply in the divorce context. If the transfer is incident to divorce, the period of ownership of the transferee spouse includes that of the transferor; and if the residence has been transferred pursuant to the terms of a divorce or separation agreement, the taxpayer is considered to use the property during any period of ownership while his spouse or former spouse is granted use of the property under such instrument.

These special rules also apply: (i) the taxpayer may elect to have § 121 not apply to a particular transaction. (e.g., two residences qualify, both must be sold, and one has greater gain); (ii) the taxpayer’s ownership includes that of a deceased spouse; (iii) the ownership requirement applies to coop stock; the use requirement applies to the coop dwelling; (iv) the exclusion is inapplicable, and gain is recognized, to the extent of any §1250 recapture; and (v) the exclusion applies to a remainder interest, provided the person is not “related” or a family member.

By combining a like-kind exchange with the § 121 exclusion, it might be possible to swap multiple rental properties for a single rental property, later convert that rental property to a principal residence, and in two years dispose of the residence and exclude gain. To accomplish this, the step transaction doctrine must be avoided.