New Rule

The rental use is now considered a ‘non-qualified use’ for exclusion from gain. The owners (sellers) will only get a prorated amount of the gain to qualify for exclusion. Gain is allocated to non-qualified use by dividing aggregate years of non-qualified use by total years the taxpayer owns the property.

Example: Assume a couple has a $600,000 gain on a house they have owned for 5 years. For the first 3 years the couple rented out the house and then moved into it using it as a primary residence for 2 years to meet the 5-year ownership requirement. They would have no exclusion for 3/5 or $360,000 of the gain on the sale. They can only take $240,000 of the §121 residential exclusion. This change prevents taxpayers from moving into their vacation home or rental property for only 2 years and then obtaining the entire exclusion upon sale.

Exception

This prorated formula applies only to non-primary (“non-qualified”) residential use that occurs before the property was last occupied as the principal residence of the taxpayer. This is a significant distinction.  Conversion of a primary residence to a rental does not preclude use of the full §121 exclusion.

Example: A taxpayer buys and lives in a home for 2 years. They move out and rent the home for 1 year.  The taxpayer is entitled to claim the entire §121 deduction. It also appears that the former provision allowing the taxpayer to utilize §1031 to defer any gain over and above the §121 exclusion remains intact.

Effective Date

Nonqualified use periods preceding January 1, 2009, are ignored. A taxpayer who placed a property into rental service in 1997 and converted it into a primary residence on 1/1/09 would be entitled to the full exclusion if they used it as their primary residence for 2 years prior to selling it.

As always, please consult our tax specialist and legal counsel for full details on how this could affect your specific tax situation.  Special thanks to Starker Exchange services for details on this change.