An article from the San Fransisco Chronicle by Benny L. Kass, Saturday, August 30, 2008 Read article
Q: I was told by a prominent accountant that there is a loophole in the law that states that you can be exempt from paying capital gains (if you are in a home less than the two-year period) if there are "unforeseen circumstances" involved. Are you aware of this? At the time I was going through an "unforeseen" divorce.
A: In general, in order to take advantage of the up-to-$500,000 exclusion of gain ($250,000 if you file a separate tax return), you have to own and live in the house for two out of the five years before it is sold. But the law does allow a partial exclusion under certain circumstances.
There are three "safe harbors," meaning that if you meet these tests the IRS will not challenge you: 1) changing to a job that is at least 50 miles farther away; 2) major health problems; and 3) unforeseen circumstances. In this third category, if you could not have anticipated an event before you purchased your house, you may also be able to claim a partial exclusion.
While this is fact-specific - and in many cases you will have to get a special ruling from the IRS - there also are some safe harbors that the IRS will recognize. These include: an involuntary conversion of your house; natural or man-made disasters resulting in a casualty to your home; divorce or legal separation; and multiple births resulting from the same pregnancy. It would appear that you may qualify based on your divorce.
The exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is two full years. If you are single - or do not file a joint tax return - change the $500,000 to $250,000.
Your accountant knows what he is talking about, so you should ask him to do the calculations. But I do not think he said that you can escape all capital gains tax.