New Rules Seek to Reduce Tax Advantages of Converting Second Home to Principal Residence

On July 30, 2008, the 2008 Housing and Economic Recovery Act, P.L. 110-289, was signed into law by President Bush. While the act was principally aimed at strengthening the ailing housing market and injecting confidence into its related government-sponsored enterprises, it did contain some noteworthy tax provisions, which largely targeted homeowners, creditors, and state and local authorities.

Because the roughly $16 billion tax arm of this housing relief package was intended to be revenue neutral, the act includes a few significant revenue offsets, one of which seeks to close, at a projected cost to taxpayers of $1.4 billion over the next 10 years, a long-standing loophole previously available to homeowners with multiple residences.

Exclusion on Sale of Primary Residence

Under Sec. 121, a taxpayer can exclude up to $250,000 ($500,000 if married filing jointly) from gross income on the sale or exchange of his or her principal residence provided the taxpayer owned and occupied the property as his or her principal residence for an aggregate two-year period during the five-year period ending on the date of the sale or exchange. The exclusion is available for repeated use over a taxpayer's lifetime but typically, excluding certain exceptions such as a change in place of employment, health, or unforeseen circumstances, it cannot be used more than once every two years.

Before the passage of this most recent legislation, taxpayers who concurrently owned one or more residences and who, at some point in the future, intended to convert a home other than their existing primary residence into their primary residence had the opportunity to exclude $250,000/$500,000 of gain from income on the ultimate disposition of these residences, provided that the ownership and use time requirements of Sec. 121(a) were satisfied. The maximum exclusion was available to these taxpayers despite the nature of the prior use of the second residence as a rental property, an investment property, a vacation property, or property used in a trade or business.

Periods of Nonqualified Use WillTrigger Gain Recognition

With the passage of the Housing and Economic Recovery Act, beginning January 1, 2009, the full $250,000/ $500,000 exclusion under Sec. 121 will no longer be available on the sale of a taxpayer's principal residence if the residence was subject to nonqualifying use prior to its ultimate disposition (Sec. 121(b)(4)(A)).

Definition of nonqualifying use: For purposes of determining the amount of the Sec. 121 exclusion, a period of nonqualifying use is defined as "any period during which the property is not used as the principal residence of the taxpayer" (Sec. 121(b)(4)(C)). For example, periods of property use as a rental property, a vacation home, investment property, or property used in a trade or business would be periods of nonqualifying use.

Note: Regardless of how the taxpayer used the property before January 1, 2009, such use is not nonqualifying use for purposes of determining the exclusion available under Sec. 121.

Computation of Recognizable Gain on Property Subjected to Nonqualified Use

The amount of gain allocable to periods of nonqualified use and ineligible for exclusion is the product of:

1. The total amount of gain and
2. A fraction composed of:
   1. A numerator, which is the sum of all the periods of nonqualified use during the period the property was owned by the taxpayer; and
   2. A denominator, which is the entire period the property was owned by the taxpayer (Sec. 121(b)(4)(B)(ii)).

Regardless of whether the home appreciates significantly after its conversion from a nonqualified use property to a taxpayer's principal residence, the taxpayer computes the amount of gain ineligible for exclusion using the above formula.

Any period of nonqualified use occurring before January 1, 2009, does not factor into the fraction used above and has no bearing on the determination of the recognizable gain.

Example 1: T, a single individual, purchases a second home in Florida on January 1, 2009, for $500,000. From January 1, 2009, until January 1, 2012, T vacations in this home and resides in his principal residence in Georgia. On January 1, 2012, after retiring and selling his Georgia residence, T moves to his Florida home and converts the vacation property into his principal residence. On January 1, 2014, T sells the Florida home for $750,000.

Of the $250,000 gain on the sale of his Florida home, only 40%, or $100,000, is eligible for the Sec. 121 exclusion. The result is a product of the total gain ($250,000) multiplied by the fraction of which the numerator is the initial threeyear period (January 1, 2009–January 1, 2012) of nonqualified use as a vacation home before conversion into a primary residence and the denominator is the fiveyear period of ownership ending January 1, 2014. Thus, T pays tax at the existing capital gains rate on $150,000 of gain. Before this law change, the entire gain would have been excluded.

Nonqualified Use Extends Beyond "Residence"

The new amendments to Sec. 121 use the word "property" rather than "residence" to ensure the broad application of the provision. It therefore appears that the definition of nonqualifying use includes the period of time that a taxpayer owns a vacant lot on which he or she intends to construct his or her primary residence before that residence is constructed and occupied so as to be construed as the taxpayer's primary residence. In addition, the period of time spent remodeling or upgrading a newly acquired residence before a taxpayer moves into this residence is likely to be deemed nonqualifying use under Sec. 121(b)(4)(C)(i).

Key Exception #1: Property First Held as Primary Residence

Homeowners can move out of their primary residence and convert it to nonqualified use property such as rental, investment, or vacation property and still be eligible for the full exclusion. The determination of the availability of the full exclusion in this instance rests with the homeowner's qualifying for the other requirements of Sec. 121 (i.e., own and occupy the primary residence for at least an aggregate of 24 of the past 60 months ending on the date of sale) at the date of disposition.

Example 2: B, a single individual, resides in her principal residence in Georgia, which she acquired for $300,000, for a consecutive 24-month period beginning January 1, 2009, and ending January 1, 2011. On January 1, 2011, B acquires a second home in Colorado and converts this home into her principal residence. For the three-year period beginning January 1, 2011, and ending January 1, 2014, B owns and maintains her Georgia residence as a second home. However, on January 1, 2014, B sells her Georgia residence for $550,000, realizing a $250,000 gain on the sale.

B may exclude the entire $250,000 of gain realized on the disposition of her primary residence. The exclusion is still available because, under Sec. 121(b)(4)(C)(ii), a period of nonqualified use does not include any portion of the five-year testing period.

In other words, because the period of time that B did not use the residence as her principal residence occurred after the last date that she used the residence as her principal residence during the Sec. 121(a) five-year testing period, such a period will not be deemed a period of nonqualified use.

Key Exception #2: Temporary Absence

Under Sec. 121(b)(4)(C)(ii)(III), a period of nonqualified use does not include a period of temporary absence, which is defined as a period of absence "due to a change of employment, health conditions, or such other unforeseen circumstances," with the period not exceeding an aggregate of two years.

The Sec. 121(b)(4)(C)(ii)(III) "temporary absence" exception is drafted using wording similar to that of the partial exclusion exception of Sec. 121(c)(2)(B). Therefore, taxpayers may be wise to ensure compliance with the existing partial exclusion safe-harbor provisions and the accompanying statutory law, case law, and IRS guidance surrounding these provisions before seeking shelter under the temporary absence exception.

Example 3: S, a single individual and a resident of Georgia, purchases a home in Florida on September 1, 2010, which she intends to immediately move into and use as her principal residence. However, two weeks after purchasing her Florida home, a hurricane severely damages the Florida property, forcing S to continue using her Georgia home as her primary residence. On September 1, 2011, when the Florida property is fully repaired, S moves into this home and maintains the property as her primary residence until she sells the home on September 1, 2016. Because the one-year period of absence from the Florida home was caused by unforeseen circumstances, S is still able to exclude the full $250,000 of gain on the sale of her Florida home on September 1, 2016.

Effect of Nonqualified Use on Sec. 1031 Exchanges

Previously, taxpayers acquiring replacement property via a Sec. 1031 exchange could, after holding the property for productive use in a trade or business or for investment purposes for a period of time, convert such property into a primary residence and avail themselves of the full exclusion under Sec. 121 upon the ultimate disposition of such property.

However, because of the nonqualified use rules, the full $250,000/$500,000 exclusion will no longer be available on the disposition of property acquired via a Sec. 1031 exchange that a taxpayer later converts into a primary residence. This occurs because the nonrecognition rules of Sec. 1031 prohibit the use of a principal residence as replacement property immediately after the exchange, thus giving rise to a period of nonqualified use following the tax-free exchange.

Similar to the pre-Housing and Economic Recovery Act law, in order to take advantage of the Sec. 121 exclusion on replacement property acquired via a Sec. 1031 exchange, the homeowner must:

• Own and occupy the property as his or her principal residence for an aggregate two-year period during the five-year period ending on the date of the sale; and
• Under Sec. 121(d)(10), own the property for at least five years before selling it.

Tax Planning Strategies

Time is running out for taxpayers to be able to take advantage of the transition period because the new rules take effect on January 1, 2009. Taxpayers could, by ensuring that their second home is converted into their primary residence before January 1, 2009, avail themselves of the full Sec. 121 exclusion on the ultimate disposition of multiple residences.

Such a strategy may be available for taxpayers who own and occupy a primary residence that, as of January 1, 2009, meets the 24-month ownership and use requirements and who, on or before January 1, 2009, are able to convert a second residence into their primary residence.

Taxpayers in this position may convert their current primary residence into a second residence on or before January 1, 2009, and, assuming that the ultimate disposition of their current primary residence does not fall outside the five-year time period of Sec. 121(a), take advantage of the full Sec. 121 exclusion as before the 2008 Housing and Economic Recovery Act.

In order to ensure that the full exclusion is also available for a property originally acquired as a second home, the second home must be converted into the taxpayer's primary residence on or before January 1, 2009. Taxpayers should take measures to ensure that this property is properly deemed the taxpayer's primary residence. Such measures include:

1. Spending a majority of time during the year at this residence; and
2. Ensuring that the address of the recently converted home is the address listed on the taxpayer's tax returns, driver's license, automobile registration, voter registration card, bills, correspondence, etc.

While such factors are certainly relevant, taking such measures does not automatically ensure the availability of the full Sec. 121 exclusion because the determination of a taxpayer's principal residence is based on all the facts and circumstances.

Finally, taxpayers facing taxable gains should spend additional time maintaining detailed records documenting tax basis and all improvements to the property.

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EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

The Tax Adviser would like to acknowledge the special contribution to the December Tax Clinic of Singer Lewak LLP; Mark G. Cook, tax partner in the Irvine, CA, office; and Steve Cupingood, the partner in charge of that firm's tax practice.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.