Thursday, August 07, 2008


From Mary Lou Scwabb at Bankers Escrow, 1031 exchange experts here in Denver came the following e-mail. The capital gains treatment will be across the board for the capital gains exclusion we have enjoyed the last few years. Like the "special loans" we who have been seasoned in the business knew would go away, this will evaporate quickly.
If you have a principle residence you were thinking of selling but thought spring might be better, if you have lived in it more than 2 years but less than the full 5, now is a very good time to look at the financial consequences of not making a move.

1031 Tax Planning Bulletin
Housing Assistance Tax Act of 2008 Affects 1031 Exchange Transactions for Property Converted into a Primary Residence
Taxpayers who 1031 exchange into a residential property and then later convert the property to a personal residence thinking they can take advantage of the principal residence gain exclusion upon the eventual sale of the property are in for a surprise! The gain exclusion could be limited. Read on . . .

Currently, a taxpayer can exclude up to $250,000 of gain realized on the sale of a primary residence ($500,000 for married couples filing jointly) if they have owned and occupied the residence for two years during the five year period preceding the date of sale (I.R.C. Section 121). Effective January 1, 2009, the exclusion will not apply to gain from the sale of the residence that is allocable to periods of "nonqualified use". "Nonqualified use" refers to periods that the property is not used as the taxpayer's principal residence.
For 1031 property converted to a principal residence any rental period prior to conversion will be considered "nonqualified use". Suppose a taxpayer exchanged into a residence and rented it for three years, and then moved into it and lived in it for two years prior to the sale. Under this new Tax Act of 2008 three-fifths of the gain would be ineligible for the gain exclusion and two-fifths would be eligible for the gain exclusion. Additionally, depreciation taken after May 1997 would be taxable at a 25% depreciation recapture tax rate. This can add up to a major tax liability!
Any nonqualified use prior to January 1, 2009 is not taken into account in the allocation. For example if a taxpayer had exchanged into a property in 2006 and rented it until 2009 prior to the conversion to a primary residence. When the taxpayer sells the residence in 2011 after two years of primary residential use, only the 2009 rental period would be considered in the allocation. Consequently, the 2009 rental period would be considered in the "nonqualified use" allocation. Only one-third of the gain would be ineligible for the exclusion.The allocation rules only apply to the time periods prior to the conversion into a principal residence and not to the time periods after the conversion out of a personal residence. Therefore, if a taxpayer converts a primary residence to a rental and other wise meets the two out of five year test under Section 121, the taxpayer is eligible for the full $250,000 single or $500,000 married exclusion when the property is sold. This new Housing Assistance Tax Act of 2008 is helpful to taxpayers with mortgage issues but creates a BIG problem for the taxpayers converting rental property into a primary residence to take advantage of the gain exclusion.

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