The 2008 Housing and Economic Recovery Act, enacted in late July, changes the rules for the partial exclusion of gain from the sale of a residence. For sales after Dec. 31, 2008, the IRC § 121 exclusion of gain will not apply to any gain allocated to a period of “nonqualified use.” Prior to this, taxpayers simply had to meet the two-year ownership and use tests to qualify for the partial exclusion.
Under the new rules, taxpayers will have to determine the amount of gain (if any) allocable to periods of nonqualified use. Gain will be allocated to periods of nonqualified use based on the ratio that aggregate periods of nonqualified use bear to the period the taxpayer owned the property.
A period of nonqualified use is defined as any period in which the property is not used as the taxpayer’s principal residence (or as the principal residence of the taxpayer’s spouse or former spouse). Note that no period before Jan. 1, 2009, will be considered a period of nonqualified use. And periods when the homeowner did not live in the residence due to military service, change of employment, health conditions or other unforeseen circumstances also do not count as periods of nonqualified use.
Before this, taxpayers who owned more than one residence could exclude up to $250,000 ($500,000 for married taxpayers filing jointly) of gain on the ultimate disposition of these residences, provided that the ownership and use time requirements of section 121(a) were satisfied for each residence. The maximum exclusion was available to these taxpayers even if the second residence had previously been a rental property, an investment property, a vacation property or property used in a trade or business.
The new provision reduces the amount of gain that taxpayers can exclude when they move into what had been their second home. Some gain from periods before the second home became the principal residence will have to be recognized.
NONQUALIFIED USE EXTENDS BEYOND "RESIDENCE"
The new amendments to section 121 use the word “property” rather than “residence” to ensure broad application of the provision. It therefore appears that nonqualified use includes the period of time that a taxpayer owns a vacant lot on which he or she intends to construct his or her primary residence before that residence is constructed and occupied.
The new rules contain two exceptions. First, homeowners can move out of their primary residence and convert it to nonqualified use property such as rental, investment or vacation property and still be eligible for the full exclusion, as long as the homeowner meets the other requirements of section 121 at the date of disposition.
Second, a period of nonqualified use does not include a period of temporary absence, which is defined as a period of absence “due to change of employment, health conditions, or such other unforeseen circumstances” with the period not exceeding an aggregate of two years.
For a detailed discussion of the issues in this area, see “New Rules Seek to Reduce Tax Advantages of Converting Second Home to Principal Residence,” by Kevin Rose, CPA, CFP, in the December 2008 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following subjects in the December 2008 issue of The Tax Adviser:
- A look at recent trends in sales and use tax nexus.
- A discussion of like-kind exchanges of partnership properties.
- An update on qualified retirement plan developments.