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Housing Assistance Act Will Impact Many Investor Capital Gain Calculations

October 9th, 2008 7:52 AM by Lehel Szucs

Housing Assistance Act Will Impact Many Investor Capital Gain Calculations
 
It has been said that the only time Americans are safe is when Congress is not in session. A possible corollary of this maxim might be that any time a widely-supported bi-partisan bill is hailed as a "rescue”, someone is liable to get hurt. Certainly, if your situation is dealt with in the portion of the bill titled Revenue, you'd better watch out.
Thus we turn to section 3092 of HR 3221 (The Housing Assistance Tax Act of 2008). There, in just a few short lines, much is taken away from what had once been given. Under current law, if you sell a property that has been your personal residence for at least two of the past five years, you may exclude from your taxable income up to $250,000 of the capital gains ($500,000 for a married couple). This is true even if the property has also been used as a rental -- as long as you meet the time period required.
Investors who have acquired the property through a 1031 tax-deferred exchange may use this provision also, although they are required to have owned the property for at least five years before they can take advantage of the exclusion. For example -- and this is a fairly common scenario -- an investor might exchange into a nice rental property which he rents out for three years. Then he moves into it as his principal residence, and sells it after two more years. In that case, the full capital gains exclusion is available.
Under the new rules, the amount of gain available for exclusion will depend on a ratio between the amount of "qualified” and "nonqualified” use of the property. Qualified use is defined as any use of the property as a primary residence. Nonqualified 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. The ratio period is based on the length of ownership of the property. Only the qualified use portion is available for exclusion from taxable gain.
The rules don't take effect until January 1, 2009, and only unqualified use after that date will be taken into account. In short, if you're selling this year, don't worry about the new rules. Moreover, in most cases, sales during the next couple of years will not have an issue.
To see how these rules work, let us consider a couple of examples. (Depreciation issues and sale costs will not be considered in the examples.) Current rules: You acquired a rental property in 2003. Your basis in it is $200,000. You rent it out for three years and then occupy it as your personal residence. In 2008, five years after acquiring it, you sell for $400,000, with a gain of $200,000. (Good for you.) The total gain falls within your individual $250,000 exclusion limit and is excluded from taxable income.
New rules: You acquire a property in 2009. Your basis in it is $200,000. You rent it out for three years and then occupy it as your personal residence. In 2014, five years after acquiring it, you sell for $400,000, with a gain of $200,000. Three of the years, 60% of the ownership period, were of nonqualified use. Thus 60% ($120,000) of the gain will be taxable. Just 40% of the gain ($80,000) represents the qualified use of the property and may be excluded from taxable (capital gain) income.
These new rules will appear as amendments to section 121 of the Internal Revenue Code. There are way, way too many scenarios, variations, and fine-print exceptions to cover in the space available here. Suffice it to say that anyone who is making plans to sell a property that has or will have both qualified and nonqualified uses needs to consult with a competent real estate tax accountant and/or attorney.
Some might be thinking, "Why all the concern about such an esoteric issue? There can't be that many who will be affected by it.” Well, prior to the vote on HR 3221, the Senate Finance Committee estimated that these new rules would raise $1.394 billion over 10 years! I don't know where they get their numbers, but there must be more than a couple of people who are going to be affected by it.
Posted in:General
Posted by Lehel Szucs on October 9th, 2008 7:52 AM

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