121 Exclusion Reduced if Non-Qualified Use

Capital gain from the sale or disposition of a homeowner's primary residence will no longer be excluded from the homeowner's taxable income under Section 121 of the Internal Revenue Code for periods of time that the residence was not used as the principal residence (“non-qualifying use”) of the homeowner BEFORE the homeowner used it as his or her primary residence.  Non-qualified use AFTER the homeowner used the property as his or her primary residence will not count against the homeowner and he or she will still qualify for the 121 exclusion treatment provided they still qualify for the 2 out of the last 5 years requirement.  See article on Changes to Section 121 for more complete details.

This change included within the Housing and Economic Recovery Act of 2008 applies to the sale of a primary residence after December 31, 2008, and, under an extremely generous transition rule, is based only on nonqualified use periods that begin on or after January 1, 2009 (i.e. all non-qualified use prior to January 1, 2009 will be ignored).

Computing Gain to Exclude and Not to Exclude

The amount of gain allocated to periods of nonqualified use is the amount of gain multiplied by a fraction, the nu­merator of which is the aggregate period of nonqualified use during which the property was owned by the taxpayer and the denominator of which is the period the taxpayer owned the property. “Non­qualified use” for this computation does not include any use prior to 2009.

Example

Adam buys property on January 1, 2009, for $400,000 and rents it for two years, claiming $20,000 of depreciation. On Janu­ary 1, 2011, Adam begins to use the property as his home. Adam moves out of the house on January 1, 2013, and sells it for $700,000 on January 1, 2014. The period 2009-2010 is non-qualifying use. The year 2013, after Adam moved out, is treated as qualifying use. Of the $300,000 gain, 40 percent (two years out of five years owned), or $120,000 is not eligible for the exclusion. The balance of the gain, $180,000, may be excluded. The $20,000 gain attributable to depreciation is recaptured, as required under current law.

So let me get this straight!

I had a property in California that I purchased in 1982 and used as a rental property till I made a 1031 exchange in 2004 to a property in Oregon.  The property in Oregon has been rented ever since.  I was planning to retire in 2010 and live in the property for 2 years and then sell at no capital gains.

But under the Housing and Economic Recovery Act of 2008, it all changes starting Jan 1, 2009.

So if I or my spouse move in to the rental before Jan 1, 2009 then everythink OK.  If we go with the original plan of selling our present home and moving into the rental at the end of 2010 and living there for 2 years, then only 50% capital gains exclusion.  Is that right?

Thanks in advance

Tim

Hi Tim,

Yes, you are correct.  The rental usage prior to January 1, 2009 will be ignored, so that will not count against you.  The rental usage after January 1, 2009 will count against you, so if you move into the property on January 1, 2011 and live there for two years you would have 2 years held as rental and two years held and used as your personal residence.  2/10ths or 50% of the gain would be excluded and 50% would not be excluded. 

We have published a more detailed article on the subject: Changes to Section 121 Tax Free Exclusion of Personal Residence. 

I have just recently started looking for a 2nd home and just learned this new modification of 121 exclusion.  My original plan was to purchase a 2nd home, rent it out for 3 years until my husband retires. Then we would move into it and change it to a primary resident, then sell it 3-4 years after that.

With this new 121 rule, we would have to prorate the capital gain between the years as rental and years as our primary home. So I am thinking about ths paragraph:

non-qualified use after the property was held and used as a primary residence will not count against the homeowner as long as the homeowner still qualifies for the 121 exclusion.

My question is HOW LONG do we need to occupy the primary residence before turnning it into a rental to qualify for exception of the new rule. Can we purchase the new home and immediate occupy it, put our current residence as 2nd home. Do this for, say, 3 MONTHS? Is there a definitive number that defines this?

After this we plan on renting it out for 2-3 years then we will move in to it again until selling it. So we eseentially are doing:

live in it --> rental --> live in it --> sell. The issue is if there is a minimal requirement for the 1st "live in it" period?

 Assuming that we do quality for 121 (24 months occupancy out of 60 months prior to sale), will this scenario quality us as the exception of the new rule.

 Thank you so much for you advice.

May

Denver

outabout:

With this new 121 rule, we would have to prorate the capital gain between the years as rental and years as our primary home. So I am thinking about ths paragraph:

non-qualified use after the property was held and used as a primary residence will not count against the homeowner as long as the homeowner still qualifies for the 121 exclusion.

My question is HOW LONG do we need to occupy the primary residence before turnning it into a rental to qualify for exception of the new rule. Can we purchase the new home and immediate occupy it, put our current residence as 2nd home. Do this for, say, 3 MONTHS? Is there a definitive number that defines this?

You could move into the property immediately so that the initial use was your primary residence.  You must live there for at least two years so that you qualify for the 121 exclusion.  Once you move out and convert it to rental you have three years in which to sell and take advantage of the 121 exclusion.  

After this we plan on renting it out for 2-3 years then we will move in to it again until selling it. So we eseentially are doing:

live in it --> rental --> live in it --> sell. The issue is if there is a minimal requirement for the 1st "live in it" period?

The second live in period is where you will have trouble because now you have rental usage prior to the primary residence usage (2nd) and will have to prorate the gain. 

 Assuming that we do quality for 121 (24 months occupancy out of 60 months prior to sale), will this scenario quality us as the exception of the new rule.

 Thank you so much for you advice.

 

Thank you so much for the quick response. Now I see the sequence of events (that determines if you live in the property first or if you rent it first)  doesn't start when the property is purchased, rather it starts by back counting 5 years when the property is sold.

Thanks again, it was very informative.

May 

Please forgive me - just want to make sure. If all that the law cares about is the 5 years prior to the sale, couldn't we do something like:

purchase the property --> rent it for 3 years --> live in for 2 years --> rent it for 3 years --> sell

and still qualify for full 121 with NO prorate?

Thanks again!

May