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|New law's reduced homesale exclusion for nonqualified use will mean headaches for sellers years down the road|
RIA Practice Alert
The “Housing Assistance Tax Act of 2008,” the 96-page tax title of the recently enacted “American Housing Rescue and Foreclosure Prevention Act of 2008” (P.L. 110-289) carries a couple of breaks for residential real estate—a new tax credit for “first-time” homebuyers and a new property tax deduction for nonitemizing homeowners—along with a controversial new restriction on the Code Sec. 121 exclusion. The restriction is intended primarily as a device to restrict or eliminate tax-free homesale profits for those who use the exclusion once on a principal residence sale and then convert a vacation home to principal residence use and sell the second home for another tax-free homesale profit. However, as this article illustrates, the complex new restriction on nonqualified use could create major headaches for those selling homes down the road, even those who never owned more than one home.
Homesale exclusion in a nutshell
Under Code Sec. 121(a), a taxpayer can exclude from income up to $250,000 of gain from the sale of a home owned and used by the taxpayer as a principal residence for at least 2 of the 5 years before the sale. The full exclusion doesn't apply if, within the 2-year period ending on the sale date, the exclusion applied to another home sale by the taxpayer. Married taxpayers filing jointly for the year of sale may exclude up to $500,000 of homesale gain if (1) either spouse owned the home for at least 2 of the 5 years before the sale, (2) both spouses used the home as a principal residence for at least 2 of the 5 years before the sale, and (3) neither spouse is ineligible for the full exclusion because of the once-every-2-year limit.
Under an election available to qualifying members of the uniformed services, Foreign Service, and intelligence community (as well as certain Peace Corps volunteers and employees serving abroad after 2007), the 5-year period ending on the date of the sale or exchange of a principal residence does not include any period of up to 10 years during which the taxpayer or the taxpayer's spouse is on qualified official extended duty.
The homesale exclusion doesn't apply to gain attributable to post-May 6, '97, depreciation claimed for rental or business use of a principal residence.
A reduced maximum exclusion may apply to taxpayers who sell their principal residence but (1) fail to qualify for the 2-out-of-5-year ownership and use rule, or (2) previously sold another home within the two year period ending on the sale date of the current home in a transaction to which the exclusion applied. If the taxpayer's failure to meet either rule occurs because he must sell the home due to a change of place of employment, health, or to the extent provided by regs, other unforeseen circumstances, then he may be entitled to a reduced maximum exclusion. Under these circumstances, the maximum gain that can be excluded is equal to the full $250,000 or $500,000 exclusion times a fraction. Its numerator is the shorter of (a) aggregate periods of ownership and use of the home by the taxpayer as a principal residence during the 5 years ending on the sale date, or (b) the period of time after the last sale to which the exclusion applied, and before the date of the current sale. The denominator is 2 years (or its equivalent in months).
For sales and exchanges after Dec. 31, 2008, the Code Sec. 121(a) rule excluding homesale gain if the two-out-of-five-year rule is met won't apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. (Code Sec. 121(b)(4), as amended by Act § 3092) Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse. For example, use of a residence as rental property or as a vacation home is nonqualified use (but see exceptions below).
RIA observation: It's important to note that the exclusion isn't reduced for nonqualified use; rather, it's the gain potentially eligible for the exclusion. Thus, if the homesale gain is large enough, the seller may be able to use the full homesale exclusion despite extensive periods of nonqualified use.
RIA illustration 1: A single taxpayer buys a residence after 2008, uses it as a vacation home for four years, and then uses it as a principal residence for four years. If he then sells the home and a realizes a gain of $500,000, half of the gain will be allocable to nonqualifying use and subject to tax as long-term capital gain, but the other half will qualify for the full $250,000 homesale exclusion.
How to allocate to nonqualified use
For determining the amount of gain that is allocated to periods of nonqualified use, gain will be allocated to periods of nonqualified use based on the ratio which:
According to the Committee Reports, gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction: (1) the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, and (2) the denominator of which is the period the taxpayer owned the property.
- the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, bears to;
- the period the property was owned by the taxpayer. (Code Sec. 121(b)(4)(B))
|RIA illustration 2: Jack Able, a single taxpayer, bought a home on Jan. 1, 2009, for $400,000, and uses it as rental property for two years claiming $20,000 of depreciation deductions (thereby reducing his basis in the home to $380,000). On Jan. 1, 2011, he converts the property to his principal residence. On Jan. 1, 2013, Jack moves out of the home and sells it for $700,000 on Jan. 1, 2014, and thus has a gain of $320,000 ($700,000 − $380,000). |
Under pre-Act law, Jack would have had $20,000 of gain attributable to depreciation deductions included in income (taxed at 25% as “unrecaptured section 1250 gain”), and would have excluded $250,000 of his gain (because he had two full years of ownership). The $50,000 balance of his long-term gain would have been taxed at a maximum rate of 15%.
Under the Housing Act change, the same $20,000 of gain attributable to Jack's depreciation deductions is included in income (and taxed at 25%). Of the remaining $300,000 gain, 40% (2 years ÷ 5 years), or $120,000, is allocated to nonqualified use and is not eligible for the exclusion (and is taxed at maximum rate of 15%). The remaining gain of $180,000 is excluded under Code Sec. 121 , since it's less than the maximum excludible gain of $250,000. Thus, the new law change costs Jack $10,500 (.15 × $70,000).
RIA observation: Presumably, the fraction will be expressed in either days or months in the same manner as the fraction that applies for determining the amount of the reduced exclusion for certain taxpayers failing to meet the ownership and use requirements or for taxpayers who have sold or exchanged principal residences within two years.
RIA observation: A period of nonqualified use (as used in the numerator in the fraction above) will not include any period before Jan. 1, 2009. But, the denominator (i.e., the period that the taxpayer has owned the property) will include periods of ownership before Jan. 1, 2009.
What is nonqualified use?
Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse.
RIA observation: After buying an existing residence, a taxpayer may take an extended period of time to remodel, improve and/or enlarge it before he actually moves into the home and begins to use it as a principal residence. During that remodeling period, the taxpayer would not be considered to be using the residence as his principal residence. Thus, that remodeling period could be construed to be a period of nonqualified use under Code Sec. 121(b)(4)(C)(i).
RIA observation: Under Reg. § 1.121-1(b), the determination of whether a property is used as a principal residence depends on the facts and circumstances. Under those rules, if a taxpayer alternates between two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. However, this majority of the time test is not dispositive if other relevant factors indicate that another residence is the taxpayer's principal residence.
|Nonqualified use does not include use that falls into one of the following three categories: |
(1) Post-principal-residence use. Nonqualified use does not include any portion of the Code Sec. 121(a) 5-year period which is after the last date that the property is used as the principal residence of the taxpayer or spouse. (Code Sec. 121(b)(4)(C)(ii))
RIA illustration 3: Jack Baker buys a principal residence on Jan. 1, 2009 and moves out on Jan. 1, 2019. On Dec. 1, 2021, he sells the property and realizes a $200,000 gain, all of which will be excluded from gross income. The property's use following Baker's departure from the property (e.g., as rental property, or vacant and held for sale) is immaterial.
RIA observation: As a practical matter, in order to qualify for the full homesale exclusion under the Code Sec. 121(a) two-out-of-five year ownership and use rule, the nonqualifying use after the owner leaves his principal residence can't exceed three years.
| (2) Qualified official duty exception. Nonqualified use doesn't include any period (not to exceed an aggregate period of 10 years) during which the taxpayer or spouse is serving on qualified official extended duty. (Code Sec. 121(b)(4)(C)(ii)) Qualified official extended duty means duty as a member of the uniformed services or the Foreign Service, or as an employee of the intelligence community. (Code Sec. 121(b)(4)(C)(ii)(II)) |
The Code Sec. 121 suspension election for members of the uniformed services, members of the Foreign Service, and employees of the intelligence community is the same as it was under pre-2008 Housing Act law. (Committee Reports)
RIA illustration 4: Jean Cody buys a house in Virginia in Year 3 (a year beginning after Dec. 31, 2008) that she uses as her principal residence for three years. For eight years, from Year 6 through Year 14, Cody serves on qualified official extended duty as a member of the Foreign Service in Germany. In Year 15, Cody sells the Virginia house. She elected to suspend the ownership and use five-year testing period for the Code Sec. 121 exclusion during her eight-year period of service in Germany (i.e., qualified official extended duty). Thus, the eight-year period is not counted in determining whether Cody used the house for two of the five years preceding the sale for purposes of the homesale exclusion (including the amount of gain allocated to periods of nonqualified use).
| (3) Temporary absence exception. A period of nonqualified use will not include any other period of temporary absence (not to exceed an aggregate period of two years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS. (Code Sec. 121(b)(4)(C)(ii)(III))|
RIA illustration 5: On Jan. 1, Year 2 (a year beginning after Dec. 31, 2008), Anne, a resident of New York, buys a house in Minnesota that she intends to use as her principal residence. Before she can move into the Minnesota house, Anne is seriously injured in an accident on Feb. 1, Year 2 and is unable to move to Minnesota until Jan. 1, Year 4. For the next three years (until Dec. 31, Year 7), she lives in the Minnesota house. On Jan. 1, Year 7, Anne sells the Minnesota house. Presumably, Anne's absence from the Minnesota house will qualify for the temporary absence exception because the absence didn't exceed an aggregate period of two years and was due to a change in health conditions (and also might have been due to unforeseen circumstances).
RIA observation: The language of the temporary absence exception is similar to the circumstances described in Code Sec. 121(c)(2)(B) that qualify for the reduced maximum exclusion (change in place of employment, health, or, to the extent provided in regs, unforeseen circumstances). RIA observation: Presumably, future IRS regs relating to the temporary absence exception will contain safe harbors similar to those provided for purposes of the reduced maximum exclusion. Thus, any safe harbors could include: a distance safe harbor for purposes of determining whether an absence is by reason of a change in place of employment; physician's recommendation safe harbor for purposes of determining whether an absence is by reason of health; and involuntary conversion safe harbor for purposes of determining whether a change is by reason of unforeseen circumstances.
Coordination with recognition of gain attributable to depreciation
For determining the amount of gain allocated to nonqualified use of a principal residence, the following rules apply:
- the rule providing that gain allocated to periods of nonqualified use does not qualify for the exclusion is applied after the application of Code Sec. 121(d)(6) (rules providing that gain attributable to post-May 6, '97 depreciation does not qualify for the exclusion), and
- the rules providing for the allocation of gain to periods of nonqualified use are applied without regard to any gain to which Code Sec. 121(d)(6) applies. (Code Sec. 121(b)(4)(D))
|Source: Federal Taxes Weekly Alert (preview) 08/28/2008, Volume 54, No. 35 |
| This information is a presentation of the general rules and should not be used or relied upon for any particular investment or transaction. We recommend you consult your tax attorney or advisor for your specific situation. If you would like more information on these matters we would be glad to visit with you. |
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Ruben Flores, CPA, JD
The Flores Law Firm
7272 Wurzbach Rd. Suite 901
San Antonio, TX 78240