Did you live in the house as your primary residence for atleast 2 years in the 5 years preceding the sale?
Did you have any other primary residence? Was the house not habitable due to flooding?
The 2 out of 5 rule starts from the date of sale of the property. In the 5 years preceding the sale, if you have used the property as your primary residence for atleast 2 years than you will be able to exclude gain upto $250K(twice if married filing jointly).
I would suggest you calculate your gain on sale of the house. Considering your original cost basis and improvements made to the house to make it saleable, there may not be any gain. Note that any insurance reimbursement and loss deduction taken on the tax return will reduce your cost basis.
Let me know if you have any question.
Please note: This advice is provided with the understanding that all the relevant facts have been provided by you. Any change in facts might affect the advice given and hence may not be relied on in such cases. Nothing contained in this reply was intended or written to be used, can be used by any taxpayer, or may be relied upon or used by any taxpayer for the purposes of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code of 1986, as amended.
You do not have to accept the answer unless you are satisfied.
You can consider that you were not able to use the house as a primary residence due to unforseen circumstances but I would suggest you to get a second opinion too. IRS does not provide detailed situations that may be considered as unforseen circumstance. Hence, it is difficult to say if your situation would be considered as being covered under unforseen circumstance. It would be a good idea to get an answer from the IRS help desk if they can offer such advise.
Section 1.121-3(a) of the regulations provides for taxpayers who fail to satisfy the ownership and use tests or the limit of one sale every two years, section 121(c) of the Code provides for a reduced maximum exclusion if the primary reason for the sale is a change in place of employment, health, or unforeseen circumstances.
Section 1.121-3(e) of the regulations provides that a sale is by reason of unforeseen circumstances if the primary reason for the sale is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. A taxpayer's reason for the sale is deemed to be unforeseen circumstances if one of the safe harbor events, such as death, divorce, or multiple births from the same pregnancy, occurs during the period of the taxpayer's ownership and use of the residence as the taxpayer's principal residence. In addition, the Commissioner may designate other events or situations as unforeseen circumstances in published guidance of general applicability or may issue rulings addressed to specific taxpayers identifying other events or situations as unforeseen circumstances with regard to those taxpayers.
Section 1.121-3(b) of the regulations provides that if a safe harbor does not apply, a sale is by reason of unforeseen circumstances only if the primary reason for the sale is unforeseen circumstances. Factors that may be relevant in determining the taxpayer's primary reason for the sale include (but are not limited to) the extent to which (1) the sale and the circumstances giving rise to the sale are proximate in time; (2) the suitability of the property as the taxpayer's principal residence materially changes; (3) the taxpayer's financial ability to maintain the property is materially impaired; (4) the taxpayer uses the property as the taxpayer's residence during the period of ownership of the property; (5) the circumstances giving rise to the sale are not reasonably foreseeable when the taxpayer begins using the property as the taxpayer's principal residence; and (6) the circumstances giving rise to the sale occur during the period of the taxpayer's ownership and use of the property as the taxpayer's principal residence.
Hope this helps...
Based on comment from another expert, I would like to add that...
You can create a case for reduced maximum exclusion under the specific even safe harbor as outlined in Publication 523...and be able to exclude gain on sale of the home.
Link below
http://www.irs.gov/publications/p523/ar02.html#d0e3182
Extract from the publication-
The sale of your main home is because of an unforeseen circumstance if your primary reason for the sale is the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home. You are not considered to have an unforeseen circumstance if the primary reason you sold your home was that you preferred to get a different home or your finances improved.
Specific event safe harbors. Unforeseen circumstances are considered to be the reason you sold your home if any of the following events occurred while you owned and used the property as your main home.
An involuntary conversion of your home, such as when your home is destroyed or condemned.
Natural or man-made disasters or acts of war or terrorism resulting in a casualty to your home, whether or not your loss is deductible.
In the case of qualified individuals (listed earlier under Change in Place of Employment):
Death,
Unemployment (if the individual is eligible for unemployment compensation),
A change in employment or self-employment status that results in the individual's inability to pay reasonable basic living expenses (listed under Reasonable basic living expenses, next) for his or her household,
Divorce or legal separation, or
Multiple births resulting from the same pregnancy.
An event the Commissioner of IRS determined to be an unforeseen circumstance in published guidance of general applicability. For example, the Commissioner determined the September 11, 2001, terrorist attacks to be an unforeseen circumstance.
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