This Capital Tax Code change caught me by surprise as I just learned about it.  I had not heard anything about it and perhaps other real estate professionals are in the same situation.  In the past I have had numerous clients that have used this section of the IRS code and several that are currently taking advantage of the code (including myself) but will now be affected as this goes into effect January 1, 2009.  Unfortunately there is nothing preventative that can be done.  A synopsis of the Internal Revenue Code follows:

A Modification of Internal Revenue Code §121

The federal government recently heightened the restrictions for those who seek to exclude capital gains on the sale of real property held as a primary residence under IRC §121.  This legislation will go into effect on January 1, 2009.

IRC §121, also known as the 121 exclusion, permits homeowners upon the sale of real estate they have owned and lived in as their primary residence to exclude up to $250,000 of the capital gains ($500,000 for a married couple filing jointly) that would have otherwise been recognized.  To qualify for this exclusion the real estate sold must be, or have been, the primary residence and lived in by the taxpayer for any two of the last five years.  Certain exceptions apply for the two year "lived in" requirement.  Taxpayers can take advantage of the 121 exclusion once every two years.

The careful utilization of the 121 exclusion has permitted taxpayers to implement strategies to take full advantage of its benefits.  Such examples include:

• A taxpayer acquires investment property, not purchased as part of a 1031 exchange, and then converts the investment property into their primary residence.  The taxpayer, after living in the property for at least two years, may sell the property and take the full 121 exclusion.

• A taxpayer acquires investment property as part of a 1031 exchange and then converts the investment property into their primary residence.  In order to take advantage of the 121 exclusion the taxpayer must live in the property for at least two years and additionally must have owned the property for at least five years. 

The latest change to IRC §121 restricts a taxpayer from taking the full 121 exclusion for periods of "non-qualified" use prior to it being held as their primary residence.  Non-qualified use is any use of the property other than as a primary residence (i.e. second home, vacation home, rental).  A "qualified" use is then, by default, any period in which the property is held as a primary residence. 

Upon the sale of the property, the capital gains attributable to the Non-qualified time period prior to its conversion to a primary residence is no longer excludable.  Any periods of Non-qualified use after conversion to a primary residence is not counted against the taxpayer, as long they would otherwise qualify for the 121 exclusion.

The allocation of capital gains between the Qualified and Non-qualified periods involves a simple fraction that takes the total capital gains associated with the sale and divides that amount between the respective periods.  The Qualified period represents the amount of the capital gains that can be excluded and is determined by the number of years the property was held as the primary residence over the total years of ownership.  The Non-qualified period represents the amount of capital gains that can no longer be excluded and is calculated using the same fraction, the number of years held in Non-qualified use over the total years of ownership.  Keep in mind, any Non-qualified periods after the conversion of the property to a primary residence is not counted against the taxpayer.

For example, a taxpayer acquired real property in January of 2009 and owned the property for eight years.  The property was held for investment for the first six years.  It was then converted to the primary residence for the last two years of ownership.  Of the total capital gains associated with the sale only one-quarter (2/8) can now be excluded under the 121 exclusion.  The remaining three-quarters (6/8) can no longer be excluded as they are allocated to the Non-qualified period.

These changes will undoubtedly impact those that have acquired investment property and intend to change the character of the property to their primary residence in order to take full advantage of the 121 exclusion. "