Updated: Amendment to §121 May Affect §1031 Exchange Planning
The Housing Assistance Tax Act of 2008, signed by President
Bush on July 30, 2008, includes a modification to the
Section121 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.
nder 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.
ffective 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. This
change applies to use as a second home as well as a rental.
ow does this affect 1031 planning? Suppose the taxpayer
exchanged into the residence and rented it for four years,
and then moved into it and lived in it for two 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
exclusion would have to be prorated as follows (the example does
not take into account deprecation taken after May, 1997, which
is taxable anyway).
n Four-sixths (4 out of 6 years) of the gain, or $200,000, would
be ineligible for the $250,000 exclusion.
n Two-sixths (2 out of 6 years) of the gain, or $100,000, would
be eligible for the exclusion.
mportantly, nonqualified use prior to January 1, 2009 is not
taken into account in the allocation for the nonqualified use
period (but is taken account for the ownership period). Thus,
suppose the taxpayer had exchanged into the property in 2007,
and rented for 3 years until 2010 prior to the conversion to a primary
residence. If the taxpayer sold the residence in 2013 after
three years of primary residential use, only the 2009 rental period
would be considered in the allocation for the nonqualified use.
Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible
for the exclusion.
n general, the allocation rules only apply to time periods prior
to the conversion into a principal residence and not to time periods
after the conversion out of personal residence use. Thus, if a
taxpayer converts a primary residence to a rental and never moves
back in, and otherwise meets the two out of five year test under
Section 121, the taxpayer is eligible for the full $250,000 exclusion
when the rental is sold. This rule only applies to non qualified use
periods within the 5 year look back period of Section 121(a) after
the last date the property is used as a principal residence.
Therefore, if the taxpayer used the property as a principal residence
in year one and year two, then rented the property for years three
and four, and then used it as a principal residence in year five, the
allocation rules would apply and only three-fifths (3 out of 5 years)
of the gain would be eligible for the exclusion.