There is a defect in the way that the main residence exemption applies where ownership of a dwelling has passed through a number of deceased estates.
Some of the most complicated deceased estate cases occur where a dwelling passes through several persons each of whom dies before a sale is made. The complexity arises because if a partial exemption is being determined, then it may not be appropriate to consider the use of the dwelling during just the last period of ownership of the deceased.
The capital gain or capital loss may often reflect changes over the entire period. This can work for or against a taxpayer, depending on circumstances. If, for example, the last deceased person used the dwelling as a main residence for a small amount of the ownership period (and not at death), but previous deceased persons used it almost entirely as a main residence, the taxpayer is aided by going back. In the opposite scenario, the taxpayer is worse off by going back.
The current provision dealing with this in the ITAA 1997 is section 118-205. It is based on section 160ZZQ(20B) of the ITAA 1936, inserted in 1990.
The ITAA 1936 provision was much more flexible than the current provision giving the Commissioner a discretion to make an appropriate adjustment if needed because it is clear that there are so many possible scenarios to consider that they cannot all be individually legislated for.
Importantly, section 160ZZQ(20B) did not apply where the taxpayer got a market value acquisition cost because if the dwelling was the (last) deceased's main residence just before death (see 160ZZQ(20B)(ba)).
That limitation is not, however, evident in the rewritten provision section 118-205.
Although there is clearly a defect which, in itself, seems beyond section 1-3 of the ITAA 1997 (see Sherlinc Enterprises Pty Ltd v Federal Commissioner of Taxation  AATA 113), there are some other features of the provision that may assist a court to get to the correct policy answer. The Note in section 118-205, though not binding, suggests that there should be no adjustment where gains and losses earlier in the inheritance chain are not included. This is also fully consistent with the Explanatory Memorandum to the ITAA 1936 provision.
This is another issue where uncertainty can lead to higher tax compliance costs
A possible solution is to amend section 118-205 of the ITAA 1997 so it states a broad principle rather than mechanics which don't cover all the cases.
That is, the provision could say you may be required to widen the examination and make appropriate adjustments to the outcome in subsection 118-200(2) where a dwelling has been acquired from a deceased individual or through a chain of individuals and the ultimate capital gain or capital loss has regard to cost bases or reduced cost bases the amounts of which would have been relevant for calculating a main residence exemption for one or more of those deceased individuals had they disposed of the dwelling immediately before death. In these cases it is appropriate to have regard to whether the dwelling was or was not the main residence of a deceased person during their period of ownership (or of a relevant person during a period trustee ownership).