Do you plan to convert an investment property into your personal residence? The Housing Assistance Tax Act of 2008 that President Bush signed into law on July 30, 2008 carried a provision that affects the practice of excluding gain when you sell a property that was once used for another purpose, such as a rental property, and then converted into your personal residence. The effect of the new law is a restriction on the amount of gain you can exclude through Section 121, the personal residence exclusion section of our tax code.

Section 121 of the Internal Revenue Code allows a gain of up to $250,000 ($500,000 if you are married and file jointly) with no tax obligation when you sell a house used as a primary residence for two of the previous five years. You don't even need to occupy the property for two consecutive years during the five year period; just two years out of the five in any form.

As of January 1, 2009, the new law reduces the amount of gain that you can exclude if you have used the property for any purpose other than as a primary residence. The reduction is applied on a pro rata basis by determining the percentage of years the property is not used as a primary residence purposes to the total years the property is owned by the taxpayer.

Sometimes examples help clarify things. Here's one: a married couple acquires a house that they use as a rental in 2009. The couple rents the house for four years, and then moves into it and uses it as their primary residence for the next two years. The couple sells the property at the end of year 6 with a gain of $300,000. Applying the old law, the couple would be eligible for the full $500,000 exclusion and would owe no tax. The new law requires the application of the proration described in the paragraph above. Two-sixths (two out of six years) of the gain, or $100,000 would be eligible to be excluded.

Exceptions to New Law:

A couple of interesting exceptions to this new restriction exist. First, periods in which the property is not used as a primary residence that occur prior to January 1, 2009 do not reduce the excludable gain. Using the example provided above, if the three year rental period occurs prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude gain on the sale up to the full $500,000.

A second interesting exception is if you convert property that you first used as your primary residence into investment property, it will not be affected by this new law. By way of example, consider this scenario: you own and live in a house for eight years, at which time you move out and rent the house for two years before selling it. Since your investment use of the property took place after your use as a primary residence, all of the gain accumulated over your 10 year ownership of the property can be excluded up to the $250,000/$500,000 limits.

There are also some limited exceptions for taxpayers who serve on "qualified official extended duty" or are temporarily absent due to changes of employment, health conditions or other unforeseen circumstances. Individuals in those situations should have their tax advisors review the new law to determine whether the exceptions could be of benefit to them.

Advance planning through consultation with your tax advisor is a must.

Combining Exclusion with 1031 Exchange

One thing that did not change is the requirement to own property for at least five years if you acquire it in a 1031 exchange and subsequently convert it to your primary residence before it is eligible for the Section 121 exclusion.

If you convert your primary residence to an investment property and subsequently sell the property, you should be eligible to combine your Section 121 exclusion with a Section 1031 tax deferral for the gain that is not excludable under Section 121.

Hopefully this did not make your head spin too much. It is clear that some complicated situations could arise out of the application of this new law. Advance planning through consultation with your tax advisor is a must. The inclusion of a knowledgeable exchange expert in the planning process would be equally beneficial.