Primary residence capital gain $250k/$500k exemption loophole closed

Many real estate investors used to take advantage of a tax loophole that allowed them to “keep their cake and eat it too”.  The old tax law allowed people to rent out an investment property for years, then move into the rental for just 2 years before selling and get the full $250k/$500k primary residence capital gain exemption.

New tax law has changed that.

Going back to basics, the primary residence exclusion allows a homeowner to exempt a portion of the capital gain from the sale of their home.

The max exemption amounts are:

 $250,000 – if you file your taxes individually – or

$500,000 – if you file your taxes married filing jointly.

To be eligible, you must own the home and live in it – as a primary residence – for at least two of the last five years prior to the sale.  Before the loophole was closed, it didn’t matter whether the 2 years were at the beginning or the end of that 5 year span.

The law previously permitted you to convert a vacation, secondary residence or investment property into your principal residence, live in it for two years, sell it and take the FULL exclusion even though a portion of the gain might have been attributable to periods when the property was used as a vacation, second home or investment property.

This strategy was used for 1031 exchange investors to exempt up to $500,000 of deferred gain in an investment property.

In 2004, the Jobs Creation Act made an additional requirement that if a 1031 exchange was involved, you had to own the property for a minimum of five years. thus you could rent a home out for three years, move in it for two and exempt the exclusionary gain.

The Housing Assistance Tax Act of 2008 changes all that. While many provisions within the new law assist struggling homeowners, a provision added takes away from the primary residence exemption rules.

Beginning on January 1, 2009, homeowners will now be required to pay tax on gains made from the sale of a second home, vacation or investment property the portion of time after that date that the home was not used as a primary residence. The amount taxed will be based on the portion of time that the house was not used as a primary residence. The rest of the gain remains eligible for the “up to $500,000” exclusion as long as the two out of five year usage and ownership tests are met.

The new law thus reduces the exclusion to the RATIO of time used as a principal residence to the TOTAL time of ownership.

For example, suppose a married couple filing a joint tax return purchases an investment property after January 1, 2009 and rents it for seven years. They then convert it into a primary residence for three years before selling it. In this situation, only 30% (3/10 years) of the gain would be eligible for the $500,000 exclusion and 70% 7/10 years) of the gain would be subject to tax. Quite a difference.

There is some good news.

a) The period of investment use before 2009 is ignored.

b) So is the period of time it is rented AFTER you move out of the residence.

Only periods of time it is rented before you made it your residence (after January 1, 2009) count.

So, if you’ve owned an investment property for the past twenty years, move into it before January 1, 2009, and live in it for two years before you sell it, the entire gain remains eligible for the tax exclusion.

So, too, is the primary residence that you lived in on January 1, 2009 but later rent out for two years before selling it. The entire gain is eligible for the exclusion.

The Act complicates deferred gains on 1031 exchanges and changes investor strategy for moving into an investment property.   You should speak with your tax advisor to ensure you fully understand your options.

Tags: investment property, Labels: 1031 exchange, primary residence, vacation homes