Principal Residence Gain Exclusion - it's not what it used to be

Somebody had to fund the benefits of the Housing and Economic Recovery Act of 2008 (P.L. 110-289) , and that may very well be you. In order to offset an estimated $2 billion of the cost of the legislated federal relief and stimulus, one of our favorite real estate tax avoidance strategies was dealt a serious blow.

Prior to amendment, Internal Revenue Code Section 121 generally allowed a taxpayer to exclude from taxation the gain from the sale of a principal residence if it was so used by the taxpayer for at least two of the five years preceding the date of the sale. Gain was fully excludable up to $250,000 in the case of a single taxpayer and up to $500,000 in the case of a married couple. This allowed us to avoid recognition of gain on the sale of business or investment property simply by living in it for at least two years before the sale. This was an easy and safe tax avoidance strategy for people who wanted to dispose of rental property or a vacation home without having to reinvest the proceeds in like real estate.

Effective Jan. 1, 2009, gain realized from the sale of a principal residence must be allocated between periods of qualified use and nonqualified use in determining how much of it may be excluded from recognition. Nonqualified use is defined as use other than as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse, and will result in at least partial taxation of gain.

Example: A taxpayer owns two properties. One is his principal residence in Boulder which he purchased in 1992. The other is a Vail vacation condo purchased Jan. 2, 2009 for $400,000. His plan had been to sell the Boulder house this fall, pocket the cash, and then move into the Vail condo on Sept. 2, 2009, when it will be worth no more than what he paid for it. The former investment property was to be converted to his next principal residence eligible for full gain exclusion merely by his living in it for the next two years. He was then going to sell it on Sept. 2, 2011, for $650,000 (happy days are here again), and pocket the entire $250,000 gain tax-free. Although that would have worked in the past, under the amended law, the taxpayer is going to have to write a check to Uncle Sam.

Let’s look at the math: The period of ownership from January 2009 through September 2011 is 32 months. The period of nonqualified use of the Vail condo before it was converted to the principal residence was eight months, or 25 percent of the time the taxpayer owned the condo. That means that $62,500 - or 25 percent - of the $250,000 gain is now taxable.

It does not matter if there was no appreciation during the period of nonqualified use. It does not matter if the property was purchased with the genuine intention of making it the principal residence as soon as possible. Gain will be taxed if there was any nonqualified use after 2008.

Although the portion of the gain from the sale of property converted from investment or business use will be reduced the longer the taxpayer occupies it as his principal residence, it will never be entirely eliminated. At least for now, this loophole has been substantially narrowed, and we will need to look to other strategies to shelter, defer and exclude gain from the disposition of real estate.