August 2008

The Housing Assistance Tax Act of 2008 includes a modification to the Section 121 exclusion of gain on the sale of a primary residence. This modification may affect taxpayers who exchange into a residential property, and then later convert the property to a personal residence, as explained below.

Under Code Section 121, a taxpayer can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale of a principal (primary) residence if they have owned and occupied the residence for two years during the five year period preceding the date of sale. Gain related to depreciation deductions taken on the property since May 6, 1997 is not eligible for exclusion.

Effective January 1, 2009, the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.” Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence. Gain is allocated to periods of nonqualified use based on the ratio which (i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.  Note that the formula uses the entire period of ownership and not just the five year look back period of Section 121(a) that is used in determining basic eligibility for the exclusion. This change applies to use as a second home as well as a rental.   

How does this affect 1031 planning?  Suppose the taxpayer exchanged into the residence and rented it for two years, and then moved into it and lived in it for four years. The taxpayer then sold the residence and realized $300,000 of gain. Under prior law, the taxpayer would be eligible for the full $250,000 exclusion and would pay tax on $50,000. Under the new law, the gain eligible for the exclusion would have to be limited as follows (the example does not take into account deprecation taken after May, 1997, which is taxable anyway).  

• Two-sixths (2 out of 6 years) of the gain, or $100,000, would be ineligible for the exclusion. 

• Four-Sixths (4 out of 6 years) of the gain, or $200,000, would be eligible for the exclusion. 

Importantly, nonqualified use prior to January 1, 2009 is not taken into account in the allocation for the numerator. (However, ownership years prior to 2009 are taken into account in the allocation for the denominator). Thus, suppose the taxpayer had exchanged into the property in 2007, and rented it for 3 years till 2010 prior to the conversion to a primary residence. If the taxpayer sold the residence in 2013 after three years of primary residential use and 6 years of ownership, only the 2009 rental period would be considered in the numerator for the allocation. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion.  

The law does not address the issue of whether the holding period of relinquished property gets added into the allocation equation when the property in question was acquired as replacement property in an exchange and therefore has a carryover tax basis.  Remember that the relinquished property holding period ‘tacks’ onto the replacement property in an exchange.  However, the law does not use the term holding period to define the allocation, but uses the “period such property was owned by the taxpayer”.  For example, suppose the taxpayer held the relinquished property as a rental property for 4 years. The taxpayer then exchanged the relinquished property for a new rental and rented the replacement property for two years. The taxpayer then converted the replacement property to a primary residence for three years prior to the sale.  Is the period of ownership of the replacement property 5 years (2 rental and 3 primary residence) or is it 9 years (6 rental and 3 primary residence).  Likewise, is the period of nonqualified use 2 years or 6 years?  Perhaps future regulations will clear up this issue.

What if a personal residence is converted to a rental and then sold within the 5 year look back period of Section 121(a)?  Non qualified use does not include any portion of the 5-year look back period after the last date that the property is used as the taxpayer’s principal residence. Thus, if the taxpayer uses the property as a personal residence for 5 years and then converts it to a rental for 2 years prior to selling it, the taxpayer is still eligible for the full $250,000 exclusion despite the 2 years of rental prior to the sale. Note that this favorable rule only applies to periods after the last date the property is used as a principal residence. Therefore, if the taxpayer used the property as a principal residence in years 1 and 2, then rented the property for years 3 and 4, and then moved back in and used it as a principal residence in year 5, the allocation rules would apply and  only three-fifths (3 out of 5 years) of the gain would be eligible for the exclusion.  

Use as a principal residence includes use by the taxpayer’s spouse or former spouse as principal residence. It also includes any period (not to exceed an aggregate period of 10 years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty, and any other period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the Secretary.

© 2008 Mary B. Foster    ‌    Disclaimer