Amendment to Sec.121 May Affect 1031 Exchange Planning
Courtesy of the Federation of Exchange Accommodators
Amendment to Sec.121 May Affect 1031 Exchange Planning
The Housing Assistance Tax Act of 2008, signed by President Bush on July 30, 2008, includes a modification to the Section121 exclusion of gain on the sale of a primary residence. This modification may affect taxpayers who exchange into a residential property, and then later convert the property to a personal residence, as explained below.
Under Code Section 121, a taxpayer can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale of a principal (primary) residence if they have owned and occupied the residence for two years during the five year period preceding the date of sale. Gain related to depreciation deductions taken on the property since May 6, 1997 is not eligible for exclusion.
Effective January 1, 2009, the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.” Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence. This change applies to use as a second home as well as a rental.
How does this affect 1031 planning? Suppose the taxpayer exchanged into the residence and rented it for three years, and then moved into it and lived in it for two years. The taxpayer then sold the residence and realized $300,000 of gain. Under prior law, the taxpayer would be eligible for the full $250,000 exclusion and would pay tax on $50,000. Under the new law, the exclusion would have to be prorated as follows (the example does not take into account deprecation taken after May, 1997, which is taxable anyway).
• Three-fifths (3 out of 5 years) of the gain, or $180,000, would be ineligible for the $250,000 exclusion.
• Two-fifths (2 out of 5 years) of the gain, or $120,000, would be eligible for the exclusion.
Importantly, nonqualified use prior to January 1, 2009 is not taken into account in the allocation. Thus, suppose the taxpayer had exchanged into the property in 2007, and rented for 3 years till 2010 prior to the conversion to a primary residence. If the taxpayer sold the residence in 2012 after two years of primary residential use, only the 2009 rental period would be considered in the allocation. Thus, only one-third (1 out of 3 years) of the gain would be ineligible for the exclusion.
The allocation rules only apply to time periods prior to the conversion into a principal residence and not to time periods after the conversion out of personal residence use. Thus, if a taxpayer converts a primary residence to a rental, and otherwise meets the two out of five year test under Section 121, the taxpayer is eligible for the full $250,000 exclusion when the rental is sold. This rule only applies to periods after the last date the property is used as a principal residence. Therefore, if the taxpayer used the property as a principal residence in year one and year two, then rented the property for years three and four, and then used it as a principal residence in year five, the allocation rules would apply and only three-fifths (3 out of 5 years) of the gain would be eligible for the exclusion.
Housing Assistance Tax Act of 2008 (H.R. 3221)
3092. GAIN FROM SALE OF PRINCIPAL RESIDENCE ALLOCATED TO NONQUALIFIED USE NOT EXCLUDED FROM INCOME.
(a) IN GENERAL.—Subsection (b) of section 121 of the Internal Revenue Code of 1986 (relating to limitations) is amended by adding at the end the following new paragraph:
‘‘(4) EXCLUSION OF GAIN ALLOCATED TO NON-QUALIFIED USE.—
(A) IN GENERAL.—Subsection (a) shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.
‘‘(B) GAIN ALLOCATED TO PERIODS OF NONQUALIFIED USE.—For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which (i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.
(C) PERIOD OF NONQUALIFIED USE. For purposes of this paragraph (i) IN GENERAL. The term ‘period of nonqualified use’ means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse. (ii) EXCEPTIONS The term ‘period of nonqualified use’ does not include (I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse, (II) any period (not to exceed an aggregate period of 10 years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty (as defined in subsection (d)(9)(C)) described in clause (i), (ii), or (iii) of subsection (d)(9)(A), and ‘‘(III) any other period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the Secretary.
(D) COORDINATION WITH RECOGNITION2 OF GAIN ATTRIBUTABLE TO DEPRECIATION. For purposes of this paragraph (i) subparagraph (A) shall be applied after the application of subsection (d)(6), and (ii) subparagraph (B) shall be applied without regard to any gain to which subsection (d)(6) applies.
(b) EFFECTIVE DATE.—The amendment made by this section shall apply to sales and exchanges after December 31, 2008.
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