Capital Gains Exclusion For The Sale Of A Primary Residence

(The Housing and Economic Recovery Act of 2008)

By Mikey and Steven Hall

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This article is intended to be a general discussion only and is not intended to, and does not give, legal advice or render legal opinions. The references contained herein were dated the moment they were written down. All sources listed must be confirmed by means of the opinions of the appropriate licensed professionals and/or recognized authoritative sources and any liability that might arise from your use or reliance on this article or any of its links is expressly disclaimed.

The "Housing and Economic Recovery Act of 2008," (H.R. 3221) passed the House on July 23, 2008 and the Senate on July 26, 2008. President Bush signed it into law on July 30, 2008. Part of the Act which affects the exclusion for capital gains on the sale of property held as a primary residence will go into effect on January 1, 2009.

IRC section 121, sometimes known as the 121 exclusion, permits homeowners who sell a property they have lived in, as their primary residence, to exclude up to $250,000 of the capital gains ($500,000 for a married couple filing jointly). To qualify for this exclusion the property must have actually been lived in as the owner's primary residence for any two of the last five years. The taxpayer can take advantage of the 121 exclusion only once every two years.

In the past, IRC section 121 has permitted a number of strategies such as acquiring a property in a 1031 tax deferred exchange then converting the property into a primary residence in order to take advantage of the section 121 exclusion. In that case the property had to owned for five years and lived in as a primary residence for at least two years.

Under the Housing and Economic Recovery Act of 2008 the taxpayer is prevented from taking the exclusion for periods of "non-qualified" use prior to it being held as their primary residence. Non-qualified means any use other use other than as a primary residence.

Upon the sale of the property, the capital gains attributable to the non-qualified time period prior to conversion is no longer excludable. Any periods of non-qualified use after conversion (e.g. use as a second home) to a primary residence is not counted against the taxpayer, as long as they would otherwise qualify under section 121.

The allocation between qualified and non-qualified use is based on a simple fraction that takes the capital gains from the sale and divides it between the periods of qualified and non-qualified use. The qualified periods can be excluded and the non-qualified periods cannot. Non-qualified periods after conversion to a primary residence are not counted against the taxpayer.

Let's assume a taxpayer obtains a home in 2009 and owns the property for eight years. For the first six years the property is owned as a rental (non-qualified use) and then in the last two years it is used as a primary residence (qualified use). Of the total capital gains exclusion on the sale of this property 2/8 of the exclusion can be taken and 6/8 of the exclusion can't.

This change will most likely affect owners who have acquired investment property with the intent of later converting it to a primary residence in order to claim the full section 121 exclusion.

As you can see, a determination of the tax consequences can be complex and we strongly suggest you consult with your tax advisor and/or your attorney when planning your tax strategy.

Contact us if you are interested in looking at available property in South Orange County. mailto:AskMikeyHall@gmail.com