Oahu Home Sales

Selling a Principal Residence Formerly Used for Investment Purposes? Amendment to IRC §121 May Reduce the $250,000/$500,000 Exclusion.

Internal Revenue Code (“IRC”) §121 allows taxpayers selling a principal residence to exclude $250,000 of gain from taxation (or, $500,000 for married taxpayers, filing jointly) as long as they have lived in the residence for 2 out of the preceding 5 years.

Alternatively, for taxpayers selling investment/rental property, while they may not exclude gain from taxation, they can nonetheless defer payment of taxes by completing their disposition as an exchange under IRC §1031.

While the rules for excluding gain from taxation or deferring payment of taxation may seem fairly straightforward under the above code sections, they become more complicated if the property was used as both a principal residence and for investment/rental purposes.

Fortunately, in February of 2005, the IRS issued Revenue Procedure 2005-14 clarifying that taxpayers are entitled to take advantage of both the §121 capital gains exclusion and the §1031 capital gains deferral. However, Rev. Proc. 2005-14 only addresses situations wherein the property being sold is investment property formerly used as a principal residence; it does not address how to apply §121 to situations when the property being sold is a principal residence formerly used for investment purposes.

Now, pursuant to the Housing Assistance Tax Act of 2008, taxpayers selling a principal residence formerly used for investment purposes, have specific guidance on the application of §121. Specifically, IRC §121 has been amended, effective January 1, 2009. Again, the amendment only affects taxpayers who are selling a principal residence (“qualified use”), which they formerly used for investment (“non-qualified use”). The central point of the §121 amendment is that these taxpayers are not entitled to the full §121 exclusion because the prior investment use is considered “non-qualified” use and any gain allocated to the period of non-qualified use may not be excluded under §121.

How to determine the amount of gain that is not eligible for exclusion:

The period of non-qualified use (period not used as a principal residence) must be divided by the total years of ownership to determine the amount of the gain that is not eligible for exclusion under §121.

Any period of non-qualified use before January 1, 2009 should not be included in the calculation. And, depreciation should also be excluded from the calculation and is simply taxed at the applicable recapture rate.

Summary of the rules under §121 amendment
• Sale of residence that was formerly investment property – the taxpayer is entitled to only a prorated portion of the $250,000/$500,000 exclusion.
• Non-qualified use prior to January 1, 2009 is disregarded, except for purposes of meeting the 5 year rule under HR 4520, if applicable1
• Gain resulting from depreciation is taxed and is disregarded for purposes of determining the prorated amount of the exclusion

Taxpayers selling a principal residence after January 1, 2009, which was formerly used as an investment/rental property should consult with their tax or legal advisors regarding the application of the amendment to §121 to their particular situation.

Significant content for this blog entry was provided compliments of:

Julie would be glad to answer any questions you had about exchanges, so contact her today…Thanks Julie, for the information….Aloha, Jon.

This entry was posted on Saturday, October 4th, 2008 at 8:55 pm and is filed under For Buyers, For Sellers, Market Watch, Oahu Information, Updates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.