Important News for Investors Regarding the “Homeowner’s Exemption”

One strategy taxpayers have used to avoid paying capital gains taxes has been to convert a rental property into a primary residence and later sell the property to take advantage of the Homeowner’s Exemption. The Homeowner’s Exemption (Section 121 of the Tax Code) allows a taxpayer to exclude up to $250K ($500K for married couples) of gain realized on the sale of a primary residence. An example of a common strategy has been:

  • Taxpayer acquires rental property in 2000 for $100K.
  • Taxpayer rents the property out for three years.
  • In 2003, taxpayer moves into the property as his/her primary residence.
  • In 2005, taxpayer sells the property for $600K.
  • Taxpayer (married couple) avoids paying taxes on the entire gain ($500K).

Unfortunately, The Housing Assistance Act of 2008, recently signed by President Bush, includes a modification to the Homeowner’s Exemption that renders the above strategy less effective. 

Effective January 1, 2009, the Homeowner’s Exemption exclusion will not apply to gain that is allocable to periods of “non qualified use”.

Non qualified use refers to periods that the property was not used as the taxpayer’s primary residence.  In our example above, the three (3) years the property was rented out is considered non qualified use, so three fifths (3/5) of the gain is ineligible for tax exclusion.  IMPORTANT NOTES:

  •  Non qualified use prior to January 1, 2009 is not taken into account.  So a property rented from 2006 to 2009, then lived in from 2009 to 2011 would qualify for the full exclusion.
  • The allocation rules only apply to periods prior to conversion to a primary.  Thus if a property was lived in for 2 years, then rented out for 3 years, and sold, the taxpayer will still receive the entire exclusion amount. 

If you have questions regarding the changes, please call Asset Exchange Company at 877-471-1031.  It is always advisable to consult with a tax or legal advisor on these issues.