Exclusion of Gain from Sale of Residence
Many people are aware that they can sell their primary residence and not pay taxes on a significant amount of gain. Under Section 121 of the Internal Revenue Code, you will not owe capital gains taxes on up to $250,000 of gain or $500,000 of gain if you are married and filing jointly, when you sell a home that you used as your primary residence for at least two of the previous five years. Taxpayers can take advantage of this exclusion once every two years.
Property Converted from Investment to Primary Residence
Taxpayers used to be able to trade into a rental, rent the home for a while, move into it and then exclude all or some of the gain under Section 121. Provided they lived in the home as their primary residence for at least two years, they could sell it and exclude the gain under Section 121 up to the maximum level of $250,000/$500,000. In recent years Congress amended Section 121 in order to limit the benefits of Section 121 when the property has also been used as a rental.
First, if you acquire property in a 1031 exchange and then convert it to your primary residence, you must own it at least five years before being eligible for the Section 121 exclusion.
Second, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced pro rata by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.
For example, a married couple uses a tax deferred exchange under Section 1031 to acquire a house as investment property. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple sells the property at the end of year 6, netting a total gain of $800,000. Instead of being able to exclude $500,000, the couple will not be able to exclude some of the gain based on how many years they rented the house. Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded. Because of this new limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.
There are a couple exceptions to this restriction. If the house was used as a rental prior to January 1, 2009, the exclusion is not affected. Using the example provided above, if the three year rental period occurred prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000.
Another important exception is that property that is first used as a primary residence and later converted to investment property is not affected by these restrictions on excluding gain. For example, if you own and live in a house for 18 years and then you move out and rent the house for two years before selling it, you can receive the full amount of the exclusion. Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 20 year ownership of the property can be excluded, up to $250,000, or $500,000 for married couples.
Combining Exclusion with 1031 Exchange
Fortunately, the rules are favorable to taxpayers who are looking to combine Section 1031 with Section 121 to both exclude and defer tax when the property starts out as a primary residence and then is converted into an investment property. Provided the personal use occurs first, you can exclude gain under Section 121, and then defer tax on the remaining gain, provided you comply with the requirements of both Section 1031 and Section 121.
The Internal Revenue Code still provides investors with favorable options for exclusion of gain and tax deferral. The rules can be complicated, but with the right planning taxpayers can still make the most of their real estate investments.
References: Internal Revenue Code §121; Housing Assistance Tax Act of 2008 (H.R. 3221).
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