It's almost that time again, you know the end of the year and all of the changes that come with it. We had our first snow here in Summit County Colorado last week. In fact it was flurrying when I got to the office this morning. I began to think about the coming winter, the ski season and realized Christmas and the New Year are just a few short months away.
I had a couple that I showed vacation homes to this weekend and after thinking about them and the rapidly approaching new year I was reminded about all the questions they had in relation to buying their first second home / investment property. They began to ask me many questions which invariably led to 1031 exchanges.
I realized that I had not yet done an update to our blog about the changes coming to 1031 exchanges for the 2009 year. Our blog has previously covered 1031 exchanges (see How to do a 1031 exchange) so we will not deal with the entire 1031 process in this entry but focus on new changes that may impact you for 2009.
An owner of a property would typically use a 1031 exchange to defer gains and other tax payments upon the sale of an investment property. To defer these taxes, the seller of an investment property buys a replacement property of equal or higher value.
The seller has to satisfy timing requirements and other rules, but if those are met, he or she is able to sell an existing investment property and then buy a new property without having to pay the IRS any taxes. One of these requirements is that the new property purchased must be used for investment purposes.
for 2009 there is a new limit on excluding a gain when converting an investment property to a primary residence.
The Housing Assistance Tax Act of 2008 signed by President Bush and pushed by congress became law on July 30, 2008. It includes a provision which limits the amount of gain that can be excluded when you sell a house used as a primary residence if you also used the house for another purpose, such as a rental.
Under the rules of Section 121 of the Internal Revenue Code, you will not owe capital gain taxes up to $250,000 of gain, or $500,000 of gain if you are married and filing jointly, when you sell a house used as a primary residence for two of the previous five years. The two year period does not need to be consecutive to qualify for the exclusion.
Under the new law and as of January 1, 2009, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced by pro-ration 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.
Ok, lets try to make all that easy to understand by using an example in the real world. A coup
le that is maried uses a 1031 tax deferred exchange to acquire a house for $500,000 they plan to use as a rental in 2009. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple decides to sell the property at the end of the sixth year for 1 million dollars, netting a total gain of $500,000. Under the new rules, instead of being able to exclude the entire $500,000, the couple will not be able to exclude some of the gain based on how many years they used the home as a rental. Since they rented it for three years out of six, 50% of the gain, or $250,000, will not be able to be excluded from their tax liability. Because of this new limitation, the couple will be able to exclude $250,000 of the gain rather than the entire $500,000 under the rules before 2009.
There are several exceptions to this new restriction that I believe buyers and investors today must know. Any periods where the property is used other than as a primary residence that occurs prior to January 1, 2009 will not reduce the excludeable gain. Using the example above, if the three year rental period occurs prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000. In other Words if you have a second home now and plan on using it as a primary residence in the near future you may want to consider doing so before January 1, 2009.
Another important exception is that property that is 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 18 years. Subsequently, 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 20 year ownership of the property can be excluded, up to $250,000, or $500,000 if you are married and filing jointly.
As always consult your tax or legal professional for advice related to investment properties. But these new rules will give you something to think about before the new year.
Jason and Deanna are real estate brokers in Summit County Colorado with a focus on second and investment properties in the resort region. See our free MLS search for Colorado resort properties.
