Section 121 - Congress Limits Gain Exclusion on the Sale of Some Primary Residences

When Congress passed the Housing Assistance Act of 2008 a few months ago, their goal was to help those people who were losing their homes in foreclosure. One of the side affects of the bill, however, was a change that could effect taxation on the gain from the sale of your personal residence.

IRS law excludes $250,000 of the gain from taxation if you're single, and $500,000 if you're married, when you sell a primary residence you've lived in for at least two years of the last five years. This is so even if a portion of the gain was rolled over into the property in a 1031 exchange transaction.

...This new law penalizes you for the time your property was not your primary residence...

For example, if you and your spouse sold a rental property in Kansas, and bought a property in Vail, Colorado, rented it out for several years, and then moved into it as your primary residence for a couple of years, your excluded gain when you sell the Vail house could include gain that was rolled into it in your exchange.

The new law modifies that rule and penalizes you for time that your property is not your primary residence; you have to prorate the gain between the periods the property was not your primary residence, and the periods that it was. (Your primary residence is the place you live; the address you use on your drivers license; where you're registered to vote, etc.)

Only the non-residence period after January 1, 2009 is excluded. So, if you bought, or exchanged into, a property on January 1, 2007, rented it for three years, moved into it on December 31, 2009, then lived in it for 3 years until you sold it, you would have owned the property for 6 years, during which it was a rental for 3 and your residence for 3. However, since only one of the rental years was after January 1, 2009, the numerator in your calculation would be one (the number of rental or non-residence years after January 1, 2009), and your denominator would be 6 (the total number of years you owned the property). In other words, 1/6 of your gain would be taxable; if your total gain was $300,000, then $50,000 of that would be taxable, even though you would otherwise be entitled to an exclusion of $500,000.

I talk about the non-residence period rather than the rental period because it's not necessary that you actually rent the property – the law deals with the periods that the property is your residence, versus the periods that it is not. In my example above, if the Vail property had been your vacation home, instead of a rental, for the three years before you moved into it, and then your residence for the next three years, the result would have been exactly the same: $50,000 of the gain would be taxable out of a total gain of $300,000.

The new law only covers those situations where the period when the property was a rental or vacation home falls before it becomes your primary residence. It does not cover situations where it was your residence first, and then became a rental property – this was done so that homeowners who were forced to rent their former residence while they tried to sell it would not be penalized.

As time goes on, we'll have lots of questions about this new law that will have to be answered by court cases or IRS rulings (such as what happens if you build a house on a piece of bare land that you've owned for years?), but my advice is that if you are planning to move into your current rental or vacation property at some point in the future, you should do so as soon possible.