Notably, there is an additional “anti-abuse” rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange. For instance, let’s imagine a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!).
To limit this activity, the Congress created “The American Jobs Creation Act of 2004 (now IRC Section 121(d)) affecting specifically tax deferred exchanges. That Act stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.
The strategy to exchange an investment rental for a new investment rental in a location where you or your customer may wish to retire takes some advance planning, but will maximize their tax savings in the end. When one exchanges their current investment rental property into a new investment rental property, they defer the tax they would normally have to pay on the gain. This is reflected in the lower basis assigned to their new replacement property. This, of course, is basic Section 1031 knowledge.
When they sell their current principal residence, they may exclude the gain up to the Section 121 limits. Then, after they convert their replacement property into their new principal residence, they become eligible once again for exclusion of up to $250,000/$500,000 of gain after they have owned the replacement property for five years and used it as a principal residence for two years. The five-year ownership rule on a principal residence only applies to properties that have come to your client from an exchange. Capital gains tax will be due on gains above the Section 121 limits and any depreciation taken after May 6, 1997.
If your customer just acquired a property by doing a like-kind exchange, they must hold the new property as an investment, rental, or business property in order to qualify for the exchange itself. We look at the facts and circumstances surrounding the exchange at the time of the acquisition. No one can tell your client how long the exchange replacement property must be held in investment status before they convert it to personal use, but most of our attorneys in our office recommend not less than one year. IRS issued Revenue Procedure 2008-16 which defines a safe harbor and includes a two-year holding period of limited personal use and a rental period if you want to be safe. We are happy to meet with clients and help you design a transaction that allows you to convert from investment to primary residence use.
Another issue we need to revisit in relation to tax deferred exchanges is that effective January 1, 2009, the IRS Section 121 was changed to require parties whether inside or outside an exchange to allocate gain based upon use. Before the President signed H.R. 3221, the Housing Assistance Tax Act of 2008, on July 30, 2008, a revenue-raising provision first promoted by Representative Charlie Rangel (D, N.Y.) was included by the conference committee as Section 3092 of the bill. This provision was an amendment to Section 121 and has had a major impact on small landlords and taxpayers who were planning to convert their rental or second home to a principal residence and then exclude any gain from their income when they sell the property.
The term “Period of Non-Qualified Use” referenced in the amendment is very important and means any period during which the property is not used as the principal residence of the taxpayer, the taxpayer’s spouse, or a former spouse. Importantly, the period before January 1, 2009, is excluded. January 1, 2009 is the date upon which this statute became law.
In addition, subsection (4)(C)(ii) of the amendment provides additional exceptions to the Period of Non-Qualified Use. These exceptions are (1) any portion of the five-year period (as defined in Section 121(a)) which is after the last date that such property is used as the principal residence of the taxpayer or spouse, (2) any period not exceeding 10 years during which the military or foreign service taxpayer, or spouse, is serving on qualified official extended duty as already defined, and (3) any other period of temporary absence (not to exceed a total of two years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the HUD Secretary.
The amendment states “gain shall be allocated to periods of non-qualified use based on the ratio which (i) the aggregate periods of non-qualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.”
How does this affect your planning?
EXAMPLE FOR ILLUSTRATION: Suppose the married taxpayer exchanged into an investment property and rented it for four years. They moved into it at that time and lived in it for two additional years. The taxpayer then sold the residence and realized $300,000 of gain.
Under prior law, the taxpayer would be eligible for the full exclusion and would pay no tax. Under the new law, the exclusion will have to be prorated as follows: four-sixths (4 out of 6 years) of the gain, or $200,000, would be taxable and thus would be ineligible for the exclusion. Two-sixths (2 out of 6 years) of the gain, or only $100,000, would be eligible for the exclusion.
Importantly, non-qualified use prior to January 1, 2009, is not taken into account in the allocation for the non-qualified use period, but is taken account for the ownership period.
EXAMPLE FOR ILLUSTRATION: Suppose the taxpayer had exchanged into the property in 2007, and rented it for three years until 2010, and then converted the property into a primary residence. If the taxpayer sold the residence in 2013, after three years of primary residential use, only one year of rental, 2009, would be considered in the allocation for the non-qualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion. Why? The period before 2009 is not counted as the law was not in effect until 2009.
SPECIAL RULES FOR PRIMARY RESIDENCE CONVERTED TO RENTAL PROPERTY
In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to all time periods after the conversion out of personal residence use. Thus, if your customer converts a primary residence to a rental and never moves back in, but otherwise meets the two-out-of-five year test under Section 121, the taxpayer is eligible for the full exclusion when the rental is sold. This rule only applies to non-qualified use periods within the five-year look-back period of Section 121(a) after the last date the property is used as a principal residence. The rule allows the taxpayer to ignore any of the non-qualifying use that occurs after the last date the property was used as a primary residence although the 2 out of the last 5 rules must be satisfied.
EXAMPLE FOR ILLUSTRATIVE PURPOSES: Your client owns a primary residence. Your client bought it and lived in it since 2008. Your client gets a job offer from California in 2014, but the economy is still in recession and decides NOT to sell then, but to hold on until the market improves. She rents it out in 2014 and takes depreciation on the house. It is now 2015 and the client wants to list the property with you for sale. Can she take advantage of Section 121 or will she be a landlord or will she be required to allocate her gain?
Even though there have been one (1) or potentially two (2) years of non-qualifying use as a rental it won’t count against her and all amounts will be excludable except for depreciation recapture. Even though your client does not live in the house as a primary residence, the client has still used the property as a primary residence two of the last five years (as she lived there in 2012 and 2013 before renting in 2014).
Happy Investing!
Today's blog courtesy of Ed McFerran, McFerran and Burns
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