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Thinking of Converting that Rental into Your Principal Residence? HOLD ON!

IRC Section 1031 allows an investor to defer capital gain taxes (and depreciation recapture) upon the sale of a property "held for productive use in a trade or business or investment" if the investor reinvests exchange equity into other investment property. IRC section 121 allows for capital gain tax exclusion upon the sale of a personal residence of up to $250,000 if a Taxpayer is single, and $500,000 if a Taxpayer is married, if the residence has been owned and used by the Taxpayer as his principal residence for an aggregate of two of the preceding five years.

In the past several years, savvy Taxpayers have been using both tax code sections together by selling and buying a rental house through a 1031 tax-deferred exchange, later converting the replacement property rental house into a principal residence, and then two years later, selling the house and excluding all of the gain under IRC Section 121. Obviously the Treasury Department has perceived this tax planning strategy as a loophole, and therefore a provision to restrict this practice was recently passed into law.

The American Jobs Creation Act of 2004, otherwise known as HR4520 was signed into law by President Bush on October 22, 2004. The law does basically what its name implies: passes a series of provisions that jumpstart job growth and positively impact U.S. businesses. Included in the HR4520 is a provision that mandates a five-year holding period requirement before a rental house previously used as a replacement property may be sold under IRC Section 121. Under this provision, a Taxpayer who exchanges into a rental house under IRC Section 1031 and then later converts the replacement property into a principal residence, is not allowed to exclude gain under the principal residence exclusion rules of IRC 121 unless the sale occurs at least five years from the date of its acquisition through the exchange.

The provisions for the new law are effective for personal residence sales occurring on or after October 22, 2004, so Taxpayers who previously acquired their current residence through a tax-deferred exchange within the past three years will now have to wait at least another two years before selling the home and excluding gain under IRC Section 121, assuming the Taxpayer meets the two out of five year occupancy test. For example, Taxpayers who are now living in a house they acquired through an exchange two years ago will now have to wait another three years before selling the house under IRC Section 121.

In accordance with the 1997 Taxpayer's Relief Act, it should also not be forgotten that depreciation recapture taxes will still be owed for the portion of time the house was used as a rental property after May 6, 1997. For example, if a Taxpayer acquired a house through an exchange five years ago, rented the house for three years, and has now lived in it the last two years, gain may be excluded under IRC Section 121, but taxes will still be owed on the total amount of depreciation taken or allowable for those three years the house was held as a rental.

In light of HR 4520 and the continuing depreciation recapture tax rule, Taxpayers who plan to convert a rental into a principal residence should be prepared to hold the new property a minimum of five years from the date of acquisition through the exchange, and should allocate money for the taxes they will owe on the depreciation they take while the house is a rental property. With proper planning and tax advice everyone wins.