After one of the longest gestation periods in real estate tax history, the IRS has issued final capital gains regulations that could affect home sellers nationwide.

The new rules, which implement key portions of tax reform legislation passed by Congress in 1997 and 1998, relate to home sale gains on properties that fail to qualify under the standard two-years-out-of-five minimum holding period. Under the 1997 tax reforms, married, joint-filing home sellers can pocket up to $500,000 of gains, and single-filing sellers up to $250,000 of gains, tax-free, provided they have owned and used the property as their principal residence for an aggregate two years out of the five years preceding the sale.

Sellers who fail to meet the two-year ownership and use test may qualify for a reduced exclusion, provided they can demonstrate that their sale was necessitated by a change in health, employment or "unforeseen circumstances." The reduced exclusion works like this: Say you buy a house in a fast-appreciating area. Eighteen months later, you are forced to sell the home because of a severe physical disability or illness. Depending upon your filing status, you might be eligible for three-fourths (18/24ths) of the $500,000 or $250,000 maximum tax-free exclusion.

On the other hand, if you sell after 18 months simply because you fell in love with another house in the area, you probably won't qualify for any tax-free exclusion, and will face full capital gains taxation on your home sale gains.

The new rules adopted by the IRS spell out the agency's standards for evaluating taxpayer claims for the reduced maximum exclusions. Some of the standards are tough. For example, on health exception grounds, you cannot claim a reduced maximum exclusion simply because you moved to improve your overall health or well-being. To the contrary, the "primary reason" for your early sale must be to "obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury."

On employment changes, the final rules require that the "primary reason" for the early sale of the house must be "a change in the location of the individual's employment." To qualify for this safe harbor, the "new place of employment must be at least 50 miles farther from the residence sold than was the former place of employment."

The rules nail down what is -- and isn't -- an "unforeseen circumstance." Unforeseen for capital gains tax purposes, according to the IRS, is "an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence." Specific safe harbor events that qualify include (1) "involuntary conversions" of the residence, such as when a local government condemns and purchases the property under its right of eminent domain; (2) a natural or man-made disaster or act of war or terrorism that results in damage to the property; (3) loss of employment; (4) divorce or legal separation; and (5) multiple births resulting from the same pregnancy.

The rules specifically allow taxpayers to argue for other "unforeseen circumstances" on a case by case basis. But a handful of possibilities are virtually ruled out in advance. For example, the IRS is not likely to be persuaded if you argue that you unexpectedly got married and therefore needed a different house. Nor is it likely to be sympathetic if you argue that you unexpectedly got a big raise at the office and could suddenly afford a fancier house, causing you to sell early.

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