As part of the Housing and Economic Recovery Act of 2008 (HR3221), Congress enacted changes via the Housing Act, Section 3092, that will--starting from January 1, 2009, change how home sellers determine the gains to be excluded from capital gain taxes. Below is an excerpt from monthly probate and realty newsletter of the American Bar Association at www.abanet.
New Restriction on Exclusions of Gain from Home Sales(Housing Act § 3092)
One of the most disadvantageous provisions in the Housing Act is the new restriction on the exclusion of gain from home sales. Under current law, a taxpayer can exclude up to $250,000 in gain ($500,000 for married couples) from the sale of a residence if the taxpayer has both owned and used the home as the taxpayer's principal residence for at least two of the five years before the sale. Thus, a taxpayer could move into a nonqualifying property (in other words, a vacation or rental property) and, after meeting the two-year residence requirement, sell the property and take advantage of the entire exclusion.
The new restriction is intended to substantially restrict tax-free home sale gains for any taxpayer who benefits from the exclusion after he or she has converted a vacation home or rental property to his or her principal residence. After December 31, 2008, gain from the sale of a principal residence will not be excluded from income to the extent the property was used for a nonqualified use, as defined under Code § 121(b)(4), as amended by Housing Act § 3092. This new restriction only applies to nonqualified uses occurring after December 31, 2008. A nonqualifed use consists of any period, beginning after December 31, 2008, in which the property is not used as the principal residence of the taxpayer.
To calculate the amount of gain that is allocated to periods of nonqualified use, the total amount of gain is multiplied by the following fraction: the aggregate periods of nonqualified use while the property was owned by the taxpayer divided by the period the taxpayer owned the property. Nonqualified use, however, does not include any portion of the five-year period that occurs after the last date the property is used as the principal residence of the taxpayer. For example, suppose John buys a home on January 1, 2009, for $400,000 and uses it as rental property for two years, claiming $20,000 of depreciation. On January 1, 2011, John begins using the property as his principal residence. On January 1, 2013, John moves out of the house and sells it for $700,000 on January 1, 2014. John used the property for a nonqualifying use for the first two years he owned it. The year after John moved out, however, is treated as a qualifying use. Therefore, 40% (two out of five years owned), or $120,000, of John's $300,000 gain is not eligible for the exclusion. The balance of the gain, $180,000, may be excluded. In addition, John must include $20,000 of the gain attributable to depreciation as ordinary income (unrecaptured Code § 1250 gain).
Nonqualified use also does not include any period during which the taxpayer or the taxpayer's spouse is serving on qualified official extended duty (not to exceed an aggregate period of 10 years), nor does it include any other period of temporary absence because of change of employment, health conditions, or other unforeseen circumstances as may be specified by the IRS (not to exceed an aggregate period of two years).
The Housing Act is intended to restrict gain exclusion when property is transferred from a nonqualifying use to a principal residence, so the new provisions do not restrict gain exclusion when property is transferred from a principal residence to a nonqualifying use. Again, this provision only applies to nonqualified uses beginning January 1, 2009.
**It's important to note that, in determining the percentage of exclusion, the owner must use the four or five year period prior to sale. The last year, to be considered as "qualified" use provided the home is not again converted to rental or investment property. Also, note that any depreciation taken during the period of non-qualified use is to be treated, upon sale, as ordinary gain and subject to a subtantially higher income tax rate. Keep this new provision in mind when counseling your clients who may be interested in selling their primary home this year.
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