I'm in a situation that I believe I understand but I'd like thoughts from others to make sure I'm thinking about this correctly. We're a family of 4 (me, DW, DS1, DS2) with me as the sole breadwinner and we bought a home in Sept 2020 for $457k. We had been diligent savers and put a nice large down payment on this and got a super low interest rate on our mortgage loan, so our payments are very reasonable. We are now selling this home and moving back to our hometown to get back to our community with support since the area we're living in now just isn't working for us (DW's decision mainly, but I'd rather keep my marriage at the expense of buying another house in this market so I'm not fighting her on this). We are scheduled to close on our home sale on Aug 13th with a sales price of $700k (crazy appreciation in less than one year!!). The crappy thing about this is is the huge capital gains tax that we'll owe since we've been in the home for less than two years and have a net profit of about $162k when including transaction costs, home upgrades, etc. Can't even get long term gains rate on this amount since we didn't even last one year.
The one glimmer of hope that I have to exempt us from the gains tax is that I started a new job for personal reasons after we moved into our home and ended up with a 28% pay cut, which forced us to cut savings to the bare bone and basically eliminate disposable income. We've had to stop all contributions to IRAs and the kids' 529s and I contribute the minimum to get my employer match for my 401k. We still have life insurance, disability insurance, emergency fund, and other "responsible adult" expenses that I can't bring myself to cut. I understand that certain situations qualify for partial exemptions if selling before the two year timeline and one of these situations is the following:
Unforeseen circumstances are defined by Treas. Reg. § 1.121-3(e)(1) as events the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. Specific-event safe harbors are provided in Treas. Reg. § 1.121-3(e)(2): involuntary conversion of the residence; disasters or acts of war or terrorism damaging the residence; or a qualified individual’s death, unemployment (if eligible for unemployment compensation), change in employment status that results in an inability to pay housing costs and basic living expenses, divorce or legal separation under a decree of divorce or separate maintenance, or a multiple birth.
I know I might be blurring the line here but I view our situation as being unable to pay housing and basic living expenses due to my salary decrease, slashing savings, etc. My budget spreadsheet shows that our average monthly cashflow is slightly negative. My question is what does the IRS require us to document to qualify for the partial exemption when we file our taxes in 2022? I have pay stubs that show my adjusted salary and a job offer letter with my current salary noted, but is something else required? How does the IRS know to accept or reject the partial exemption?
Feel free to ask clarifying questions if I didn't provide enough information. I'm looking forward to hopefully getting back to a stable situation next year after tax season!