INVESTMENT PROPERTY CONVERSION

Limit on Excluding Gain When Converting

            Effective January 1, 2009, The Housing Assistance Tax Act of 2008, limits the amount of gain that can be excluded when you sell a house/condo used as a primary residence and as investment property

            As of January 1, 2009, the amount of gain that you can exclude will be reduced to the extent that the house or condo was used for something other than a primary residence during the period of ownership. During ownership, the exclusion reduction is pro rated by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer. As before, if you acquire a property in a 1031 exchange, and then convert it to your primary residence, you must own the property at least five years before being eligible for the 121 exclusions.

            Below are two scenarios incorporating this new law, who used a tax deferred exchange under Section 1031 to acquire a property used as a rental in 2009.

Example 1:     January 1, 2009, a single person purchases and rents the investment property for three years and uses the house as his or her primary residence for the next two years. The house is at the end of five years has a net gain of $500,000.¹  With the new rules, they rented the house 60% and lived in it 40% of the time.

Lived in the house as a primary residence 2 years

Total ownership is 5 years

2 ÷5 = .4 or 40%

$500,000       Net Gain

x      40%        (percentage of time they lived in the house)

$200,000       Total Exclusion Allowed on the Converted Property, Because of the New Limitation (not $250,000)

Example 2:     A couple rents the investment property for three years, and uses the house as their primary residence for the next three years. The house at the end of six years has a net gain of $800,000.²

Lived in the house as a primary residence 3 years

Total ownership is 6 years

3 ÷6 = .5 or 50%

$800,000       Net Gain

x      50%        (percentage of time they lived in the house)

$400,000       Total Exclusion Allowed on the Converted Property, Because of the New Limitation (not $500,000)

There are exceptions to the new law. Some of the main exception points are:

Exception 1:   Prior to January 1, 2009, any periods where the investment property is used other than as a primary residence will not reduce the non-inclusion gain. Using both examples, if the three-year rental period occurs prior to January 1, 2009, the exclusion would not be reduced and the owners would be able to exclude the full $250,000 (single) and $500,000 (married).

Exception 2:   Property first used as a primary residence and later converted to investment property will not be affected by this new law. For example: you own and live in a house for 10 years. Then you move out and rent the house for two years before selling it. Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 12-year ownership of the property can be excluded, up to $250,000 (single), or $500,000 (married and filing jointly). If the personal use occurs first, you may exclude gain under Section 121, and then defer tax on the remaining gain.

Exception 3:               There are some exceptions to taxpayers who serve on "qualified official extended duty" or are temporarily absent due to changes of employment, health conditions, or other unforeseen circumstances. Each person should check with their CPA or other tax professional.