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Internal Revenue Code Section 121 allows taxpayers selling a primary residence to exclude $250,000.00 of gain from being taxed ($500,000.00 for married taxpayers, filing jointly) if they have lived in the residence two out of the last five years.
The Housing Assistance Tax Act of 2008 includes a modification to the Section 121 exclusion of gain. This modification may affect taxpayers who exchange into a residential property, and then later convert the property to a personal residence.
Effective January 1, 2009, the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “non-qualified use.” Non-qualified use refers to periods that the property is not used as the taxpayer’s principal residence.
BRIEF SUMMARY OF THE RULES:
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Only applies to conversions into personal residence not out of personal residence.
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Non-qualified use prior to January 1, 2009 is disregarded (except for purposes of meeting the 5 year rule under HR 4520)
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The taxpayer is entitled only to a prorated portion of Section 121.
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Gain from depreciation is taxed and is disregarded for purposes of determining the prorated amount
HOW DOES THIS AFFECT YOU?
A taxpayer exchanges into a residence and rents it for four years and then lived in it for two years. The taxpayer decides to sell the residence and would realize $300,000.00 of gain. Under the prior law, the taxpayer would be eligible for the full $250,000.00 exclusion and would pay tax on $50,000.00. Under the new law, the exclusion would have to be prorated as follows.
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Four-sixths (4 out of 6 years) of the gain, or $200,000, would be “ineligible” for the $250,000 exclusion.
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Two-sixths (2 out of 6 years) of the gain, or $100,000, would be eligible for the exclusion.
Additionally, non-qualified use prior to January 1, 2009 is not taken into account in the allocation for the non-qualified use period (but is taken account for the ownership period). Thus, suppose the taxpayer had exchanged into the property in 2007, and rented it for 3 years until 2010 prior to the conversion to a primary residence. If the taxpayer sold the residence in 2013 after three years of primary residential use, only the 2009 rental period would be considered in the allocation for the nonqualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be “ineligible” for the exclusion.
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