Taxation & Estate Planning

CONVERSION PROPERTY MAY HAVE LIMITED SECTION 121 EXCLUSION

By Charles Rubin

Code Section 121 allows taxpayers to exclude up to $250,000 of gain from sale of a principal residence from federal income taxation ($500,000 for married couples). To qualify for the exclusion, the sold residence must have been used as the taxpayer's principal residence for at least 2 years in the 5 years preceding sale.

The Housing Assistance Tax Act of 2008 has enacted a new limitation on the exclusion. Code Section 121(b)(4) now provides that if a residence was at any time NOT used as a principal residence of the taxpayer, the portion of the gain allocated to periods of "nonqualified use" will not be available for exclusion. Thus, if a taxpayer rented out a residence or used it only as a vacation home for a period, but still otherwise used the residence as a principal residence for the requisite 2 years out of the preceding 5, the full exclusion may not be available.

The available portion of the gain available for exclusion is determined by multiplying the gain on sale by a fraction. The numerator is the period that the residence was used as a principal residence by the taxpayer, and the denominator is the entire period of ownership of the taxpayer. The resulting amount of gain is eligible for exclusion (up to the maximum $250,000/$500,000 exclusion limits), and the remaining gain is not excluded.

There are some finer details to the new rules, including:

a. In applying the above "nonqualified use" fraction, the period of "nonqualified use" in the numerator does not include periods before 1/1/09 (but such periods before 1/1/09 are not excluded from the denominator);

b. The numerator also does not include any time period of "nonqualified use" arising in the prior 5 years before sale that occur AFTER use a principal residence;

c. The numerator also does not include periods of "nonqualified use" (up to 10 years) due to service as a member of the uniformed services or the Foreign Service, or as an employee of the intelligence community; and

d. The numerator also does not include periods of "nonqualified use" (up to 2 years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS.

Note that the formula determines how much of the GAIN is eligible (and not eligible) to be subject to the exclusion - it does not adjust the statutory amount of the exclusion. Thus, in some circumstances, if the gain amount is high enough and a small enough portion is treated as allocable to nonqualified use, the remaining gain may still be excluded by the full applicable statutory exclusion amount. For example, if the taxpayer has $1 million of gain, and 1/5 of the gain is treated as allocable to periods of nonqualified use, $800,000 is still eligible for the statutory exclusion (up the available $250,000/$500,000 maximum). Thus, the full statutory exclusion amount may at times still be available even with periods of nonqualified use, given enough gain.

Full post as published by Rubin on Tax on August 24, 2008 (boomark / email).