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Tax Free Exclusion on the Sale of a Primary Residence May Be Significantly Reduced under Certain Circumstances

 

The Housing and Economic Recovery Act of 2008
Modifies Section 121 of the Internal Revenue Code


Introduction

The Housing and Economic Recovery Act of 2008, as with any piece of new legislation, has certain provisions incorporated within it other than what the title of the act would lead you to believe.  A provision contained within the Housing and Economic Recovery Act of 2008 amends Section 121 of the Internal Revenue Code.

Section 121 of the Internal Revenue Code

121 Exclusion 

Section 121 of the Internal Revenue Code, which is often referred to as the 121 exclusion, generally allows homeowners to sell real property held (owned) and used (lived in) as their primary residence and exclude from their taxable income up to $250,000 in capital gains per homeowner, and up to $500,000 in capital gains for a married couple filing a joint income tax return. 

Primary Residence 

The 121 exclusion can only be used in conjunction with real property that has been held and used as the homeowner’s primary residence.  It does not apply to second homes, vacation homes, or property that has been held for rental, investment or use in a trade or business. 

Qualifications 

Homeowners are required to have (1) owned and (2) lived in the real property as their primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years) in order to qualify for the 121 exclusion.  The 24 months does not have to be consecutive. There are certain exceptions to the 24 month requirement when a change of employment, health, military service or other “unforeseen circumstances” have occurred. 

Combining Sections 1031 and 121 

Strategies of combining the 1031 exchange and the 121 exclusion have become very popular over the last few years, especially after the American Jobs Creation Act of 2004 was enacted by Congress and after the Internal Revenue Service issued Revenue Procedure 2005-14, both of which helped clarify the homeowner’s ability to use the combined 1031 exchange and 121 exclusion strategies.  The combined strategies enabled homeowners to convert tax-deferred income into tax-free income. 

Combined Income Tax Strategies 

Generally, homeowners were structuring and implementing three (3) different income tax strategies, which involved converting real estate between investment (rental) and primary residence usage. 

The three (3) combined income tax strategies included:

  1. Rental property that was never part of a prior 1031 exchange is converted into a primary residence. The homeowner converts the rental property into the homeowner’s primary residence.  The homeowner must live in the property for at least 24 months in order to qualify for the 121 exclusion.  The homeowner can then sell the primary residence and take the 121 exclusion. 
  2. Rental property that was acquired as part of a prior 1031 exchange is converted into a primary residence.  The homeowner converts the rental property into the homeowner’s primary residence.  The homeowner must live in the property for at least 24 months in order to qualify for the 121 exclusion.  Because the rental property was part of a prior 1031 exchange the homeowner must also have owned the property for at least five years in order to take advantage of the 121 exclusion.  The homeowner can then sell the primary residence and take the 121 exclusion.  
  3. The homeowner’s primary residence is converted into rental property.  The homeowner should hold the property as investment (rental) property for at least 12 months in order to prove they had the intent to hold the property for investment use and qualify for 1031 exchange treatment.  The homeowner can then sell the rental property and take the 121 exclusion (provided they qualify for the 121 exclusion) and they can complete a 1031 exchange to defer the balance of the capital gains not excluded under Section 121.  This strategy is defined in Revenue Procedure 2005-14. 

Excludes Capital Gains; Not Depreciation Recapture

The 121 exclusion allows homeowners to exclude capital gains but not depreciation recapture from their taxable income when they sell their primary residence that was also held as an investment property.  The depreciation recapture would be recognized in the year the primary residence is sold even if the homeowner qualifies for the 121 exclusion.

Homeowners can take advantage of the 121 exclusion once every two years.

Changes to Section 121

The Housing and Economic Recovery Act of 2008 amends Section 121 of the Internal Revenue Code.  Section 121 no longer permits homeowners to take the full tax-free exclusion on the sale of real property that was held and used as their primary residence if there was any non-qualified use of the real property prior to it being held and used as their primary residence.

Qualified and Non-Qualified Use

Qualified use is defined as any use of the property as a primary residence.  Non-qualified use is defined as any use of the property other than as a primary residence, including use as a second home, a vacation property, a rental or investment property or use in a trade or business.

Gain Can Not Be Excluded for Non-Qualified Use

Homeowners can no longer take the full tax free exclusion under Section 121 when the property was held and used for non-qualified use prior to it being held and used as a primary residence (qualified use). 

The capital gain resulting from the sale of the property will be allocated between qualified and non-qualified use periods based upon the amount of time the property was held and used for qualified versus non-qualified use.

The capital gain allocated to the non-qualified use period will no longer be excluded from the homeowner’s taxable income.  The capital gain allocated to the qualified use period (time used as a primary residence) will continue to qualify for the 121 exclusion and will be excluded from the homeowner’s taxable income.

However, non-qualified use after the property was held and used as a primary residence will not count against the homeowner as long as the homeowner still qualifies for the 121 exclusion (see Exceptions to Non-Qualified Use).  Homeowners that still qualify for the 121 exclusion will still receive the full tax free exclusion under Section 121. 

Allocation of Capital Gain between Qualified and Non-Qualified Use Periods 

Homeowners do not need to determine when the subject property actually appreciated or depreciated in value.  There are no appraisals needed or required.  The change or fluctuation in the fair market value of the property each year during the time they owned it doesn't matter.  The total capital gain recognized upon the actual sale of the property is all that matters.

The total capital gain recognized upon sale will be allocated between qualified and non-qualified use periods in order to determine the amount of gain to be excluded from taxable income under Section 121 of the Internal Revenue Code due to qualified use, and the corresponding amount of capital gain that will be included in taxable income (not excluded) under Section 121 due to non-qualified use. 

The allocation of the gain between qualified and non-qualified use periods is actually very simple.  Gain is allocated using a formula or fraction based on the number of years the property was held for qualified use versus the number of years the property was held for non-qualified use as a percentage of the total number of years the property was owned by the homeowner.

Example

A homeowner owned real property for ten (10) years.  It was held as rental property for the first eight (8) years and then converted to their primary residence for the last two (2) years.  The non-qualified use period is eight (8) years and the qualified use period is two (2) years.

In this example, 2/10ths of the total actual capital gain can be excluded from taxable income as qualified use under Section 121 and 8/10ths of the actual total capital gain must be included (not excluded) in the homeowner’s taxable income as non-qualified use under Section 121.

Remember that any depreciation recapture can not be excluded from taxable income under Section 121 and would be recognized and included in the year the property is actually sold.  In this example, the depreciation taken over the eight (8) year period while the property was held for investment will be recaptured and taxable in the last year when the property is actually sold.

Exceptions to Non-Qualified Use

The Housing and Economic Recovery Act of 2008 has provided three (3) exceptions to homeowners where the sale of their primary residence may not otherwise qualify for the tax free exclusion under the new requirements now included in Section 121.

  1. The first exception will have the greatest impact.  Homeowners can move out of their primary residence and convert it to any other non-qualified use such as rental, investment, vacation, or business use property and still qualify for the tax free exclusion under Section 121.

    The key is that homeowners must still qualify for the other requirements under Section 121 at the time they close on the sale of their primary residence.  They must have (1) owned and (2) lived in the real property as their primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years) in order to qualify for 121 exclusion treatment.
  2. This also means that Revenue Procedure 2005-14 still applies and that homeowners can also complete a 1031 exchange to defer any balance of capital gains above the 121 exclusion limitations. 
  3. The second exception involves those homeowners affected by qualified official extended duty such as military service.
  4. The third exception involves unforeseen circumstances.

Summary of Changes

Property Held For Rental or Investment First

Property held for investment purposes and then subsequently converted into a primary residence will be impacted the most under these legislative changes to Section 121.

The amount of time that the real property was held as investment property (non-qualified use) will no longer qualify for tax free exclusion under Section 121.  Only the actual time that the real property was held and used as a primary residence (qualified use) will qualify for the tax free exclusion.

This will significantly affect those homeowners who had planned to move into investment property and convert its usage to their primary residence in order to take advantage of the 121 exclusion.  The longer the real property was held for investment the greater the impact will be on the amount of capital gain that can be excluded from taxable income (i.e. the more capital gain that must be included in taxable income).

Property Held As Primary Residence First

The modifications made to Section 121 do not affect homeowners that move out of their primary residence and convert it to non-qualified use.  The homeowner can still take the full amount of the 121 exclusion upon the sale of the property as long as they still qualify for the 121 exclusion.

In other words, a primary residence that is subsequently converted into investment property will still qualify for the tax free exclusion under Section 121 provided the property is sold no later than three (3) years after its conversion to investment property.  The property will no longer qualify for the 121 exclusion once it has been held by the homeowner as investment property beyond the three (3) year window.

Effective Date of Changes

The modifications to Section 121 of the Internal Revenue Code apply to the sale of any real property closing after December 31, 2008 that was held and used as the homeowner’s primary residence.

Transitional Period

The Housing and Economic Recovery Act of 2008 provides a very generous transition period to help homeowners plan for the modifications to Section 121.  Any and all non-qualified use of the property prior to January 1, 2009 will not be taken into account and is ignored for 121 exclusion treatment; only the non-qualified use of the property after December 31, 2008 will affect homeowners.

Example

Kimberly buys her property on January 1, 2009 for $400,000 and leases it out for two (2) years.  Kimberly claims $20,000 of depreciation deductions for those two (2) years.  On January 1, 2011, Kimberly converts the property and begins to use the property as her primary residence.  Kim moves out of her property on January 1, 2013, and subsequently sells it for $700,000 on January 1, 2014.

The period from 2009 through 2010 is non-qualified use of the property because it was held as investment (rental) property. The year 2013, after Kimberly moved out, is treated as qualified use of the property because of the exception provided in the Housing and Economic Recovery Act of 2008 as discussed above.

Out of the $300,000 capital gain, 40 percent or 2/5ths (two years out of five years owned), or $120,000, is not eligible for the tax free exclusion. The balance of the capital gain, or $180,000, may be excluded tax free under Section 121. The $20,000 gain attributable to the depreciation deductions is recaptured, as required under current law. 

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