When Congress passed the Housing Assistance Act of 2008, their goal was to help those people who were losing their homes in foreclosure. One of the side effects of the bill, however, was a change that could affect taxation on the gain from the sale of YOUR personal residence.
If you sell a primary residence you've lived in for at least two years, section 121 excludes $250,000 of the gain from taxation if you're single and $500,000 if you're married. This is true even if a portion of the gain was rolled over into the property in a 1031 exchange transaction. For example, if you and your spouse sold a rental property in Kansas, bought a property in Vail, rented it out for several years and then moved into it as your primary residence for a couple of years, your excluded gain could include gain that was rolled over in your exchange.
This new law modifies that rule and penalizes you for the time that your property was not your primary residence; you effectively have to prorate the gain between the period that the property was not your primary residence and the period 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 another three years until you sold it, you would have owned the property for six years: three of which it was a rental and three of which it was your residence. However, since only one of the rental years was AFTER January 1, 2009, the numerator in your calculation would be ‘1' (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 say the NON-RESIDNECE period rather than the RENTAL period because it's not necessary that you actually rent the property - the law deals with the period that the property is your residence and the period 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 it was your residence for the next three years, the result would be exactly the same: $50,000 of taxable gain out of a total gain of $300,000.
The new law only covers those situations where the rental period or vacation home period falls before the primary residence period. 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 our questions about this new law will 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 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.
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