Texas Ranch Connection - Index

Texas Ranch Connection - Texas Ranch Connection - Index

14
Reduced Homesale Exclusion - Don’t Panic!
The recently passed Housing Assistance Tax
Act of 2008 had at least one provision that
wouldn’t have been on any 1031 exchanger’s
wish list. Headlines described the change to
Code Section 121 with phrases such as “will
mean headaches” or “house-hoppers may suffer”.
But there is no need to get out the
checkbook for the IRS yet!
The change was Congress’ attempt to foil a
common tax reduction strategy that combines
1031 exchanges with the Sec. 121 personal
residence exclusion. The code allows homeowners
to exclude up to $250,000 ($500,000
for married couples) of gain from a sale of personal
residence. Exchangers took advantage
of the exclusion using a two-step strategy.
First, exchangers would defer tax on the
gain on sale of an investment or business
use property by exchanging into a rental
house. Next, after renting the house for
some period of time (assume two years),
the exchanger would move into the house
and convert to a personal residence
(assume two years). At this point, the
exchanger has met the “live in 2 of the last
5 years” eligibility requirement for the
exclusion. However, the exchanger still
had one more hurdle to cross before the
exclusion was available. A special rule limits
the availability of the personal residence
exclusion to exchangers until five years
after the exchange property’s acquisition
date (assume the exchanger continues to
live in it one more year). Five years after
purchase, the full exclusion becomes available.
At that point, the exchanger may sell
the personal residence and use the full
exclusion to permanently eliminate gain.
The only portion of the gain that is taxable
would be the recapture of two years of
depreciation while it was a rental.
The change to Sec. 121 reduces the gain eligible
for exclusion relative to the exchanger’s
“nonqualified use” during the entire period
of ownership. Nonqualified use is defined
as any period during which the property is
not used as the principal residence of the
taxpayer. It is important to note that nonqualified
use affects the taxpayer only if the
use is before conversion to the exchanger’s
personal residence.
EXAMPLE: Assume married filing jointly taxpayers
exchange into a rental house and rent
the house for three years. The house is converted
to a personal residence for two full
years. Finally, the house is rented out for an
additional year before being sold for a total
gain of $620,000 including $20,000 of depreciation
recapture. The $20,000 is taxable at
the 25% special recapture tax rate. The term
of nonqualified use during ownership was
two years. The final one year of rental activity
is excluded from nonqualified use since it
occurred after the house was used as a personal
residence. So, 33% of the term of ownership
was attributable to nonqualified use
resulting in $200,000 of the gain being ineligible
for the exclusion. In the end, $400,000
of gain is excluded from taxation.
This change not only challenges exchangers,
but also vacation home owners who
choose to convert vacation homes to personal
residences.
EXAMPLE: Married filing jointly taxpayers
own a vacation home for six years, then convert
to a personal residence for two years
before selling for a gain of $400,000. Since
the vacation home period is considered a
period of nonqualified use, six of the eight
years or 75% of the gain will be ineligible for
the exclusion. In the end, only $100,000 of
the gain can be avoided for tax purposes.
Do not panic! The key right now is that
any nonqualified use that occurs before
1/1/09 is not included when computing the
gain that is ineligible for the exclusion.
And there is another cool little wrinkle that
benefits taxpayers. Even though nonqualified
use before 2009 doesn’t count, the law
permits ownership before 2009 to be taken
into account in the calculation.
Example: Taxpayer owned vacation home
for six years before 1/1/09. Taxpayer continued
using the property for two additional
years as a vacation home, then converted
it to a personal residence for two
additional years. Taxpayer sold the house
and realized a $300,000 gain. The nonqualified
use calculation is two years
unqualified divided by ten total years of
ownership. The result is that 20% or
$60,000 of the gain is ineligible for the
personal residence exclusion.
While there is no need to get excited now,
you may want to consider the following
strategies if you have a situation that could
be affected by the new rule:
Exchange property converted
to personal residence:
If you have exchanged into a rental and it is
seasoned as 1031 qualified exchange property
(rented for a sufficient period of time),
move into the house by 1/1/09 to begin
your two years and eliminate any nonqualified
use period.
Even if you want to hold the property longterm,
convert to a personal residence on
1/1/09 for some period of time (not defined
but doesn’t have to be two years- assume at
least one year) which eliminates any future
nonqualified use calculation.
Down the road, if exchange properties
have been rented for substantial periods of
time post-2008 (nonqualified use),
exchange the property for a new rental,
rent for two years then convert to a personal
residence. That will limit the nonqualified
use to a maximum of two years for the
nonqualified use calculation.
Vacation property converted
to personal residence:
Move into your vacation home by 1/1/09 to
eliminate any nonqualified use period for now
and in the future. As mentioned above, probably
at least one year should permanently put
the skids on any nonqualified use calculation.
If you buy a new vacation home, consider
living in it for the first year to eliminate all
future nonqualified use calculations.
All in all, good planning can eliminate most
of the effects of the change to Sec. 121. And
remember; don’t worry about nonqualified
use before 2009. It doesn’t count!!
Have more questions on the change? Call
Summit 1031 Exchange!