Changes To Section 121 Effective January 2009
Housing Assistance Tax Act of 2008- Modifications to Section 121
The Housing Assistance Tax Act of 2008 includes a modification to Section121, the Universal Exclusion for the sale of a primary residence. This modification may affect taxpayers who exchange into a property and later convert it to their primary residence.
Section 121 allows an individual to sell his/her primary residence and receive a tax exemption on $250,000 of the gain or $500,000 as a married couple filing jointly, as long as the property has been held as the individual’s primary residence for an aggregate of 2 of the preceding 5 years. Gain related to depreciation 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 a residence that is allocable to periods of “nonqualified use.” The IRS describes nonqualified use as “periods (of time) that the property is not used as the taxpayer’s primary residence.” This includes the use of a second home as well as a rental property.
Suppose a taxpayer exchanged into a property and rented it for four years, then moved in and lived there for two years. The taxpayer then sold the residence and realized $200,000 of gain. Under prior law, the taxpayer would be eligible for the full $250,000 exclusion and therefore would have no tax exposure due to appreciation. 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). Four-sixths (4 out of 6 years) of the gain, or $133,333 would be ineligible for the $250,000 exclusion, while two-sixths of the gain, or $66,667, would be excluded.
Nonqualified use prior to January 1, 2009 is not taken into account in the allocation for the nonqualified use period (but is taken into account for the ownership period). Thus, suppose the taxpayer had exchanged into the property in 2007, rented it for 3 years till 2010 prior to the conversion to a primary residence. If the taxpayer sold the residence in 2013 after three years as a primary residence, only the 2009 rental period would be considered nonqualified use. Thus, only one-sixth of the gain would be ineligible for the exclusion.
In general, the allocation rules only apply to time periods prior to the conversion into a primary residence and not to time periods after the conversion to primary residence use. If a taxpayer converts a primary residence to a rental and never moves back in, and otherwise meets Section 121 requirements, the taxpayer is eligible for the full $250,000 exclusion upon sale. This rule only applies to non-qualified use periods within the 5-year look back period of Section 121(a) after the last date the property is used as a primary residence. Therefore, if the taxpayer used the property as a primary residence in year one and year two, then rented the property for years three and four, and then used it as a primary residence in year five, the allocation rules would apply and only three-fifths of the gain would be eligible for the exclusion.
