In October of 2008, two significant changes were made to the Federal income tax laws affecting capital gains on the sale or exchange of real property.
Principal Residence Exclusion – 26 U.S.C. § 121
As part of the New Housing Rescue and Foreclosure Prevention Act of 2008, Congress made a significant, and little reported, change to the law concerning the exclusion from gross income of capital gain from the sale of a principal residence. This change seemingly was an afterthought, and was slipped into the Act as a revenue offset at the very end of the bill.
26 U.S.C. § 121 currently excludes from gross income gain on the sale or exchange of property up to a maximum of $250,000 ($500,000 for joint filers) if, during the five years preceding the sale or exchange, the property was owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating at least two years. The new law does not change this concept. However, it disallows from the exclusion the pro rata portion of the gain that corresponds to any period of “nonqualified use” after 2008.
“Nonqualified use” is defined as use other than as the taxpayer’s principal residence. However, any period of time during the last five years of the taxpayer’s ownership of the property after the last date the property was used as the taxpayer’s principal residence is not included in the period of “nonqualified use.” By way of illustration, if a taxpayer owns property from 2009 through 2018, but uses it as his principal residence only from 2011 through 2015, he can exclude 80% of the gain from a sale or exchange of the property.
There also are limited exceptions for temporary absence due to national service, change of employment, health and other unforeseen circumstances. As is characteristic of the Internal Revenue Code, 26 U.S.C. § 121 contains exceptions to exceptions to exceptions.
26 U.S.C. § 121 is applicable to sales and exchanges that occur after December 31, 2008.
For years there has been uncertainty about the circumstances under which a taxpayer’s vacation home can qualify for deferral of gain as “property held for productive use in a trade or business or for investment” under 26 U.S.C. § 1031, with the primary guidance being a Tax Court case that established a fact-specific “primary use” test.
The IRS recently resolved the uncertainty by issuing Revenue Procedure 2008-16, which went into effect March 10, 2008. Rev. Proc. 2008-16 establishes a safe harbor for determining whether a home qualifies for deferral of gain as relinquished property or replacement property under 26 U.S.C. § 1031. The safe harbor criteria are as follows:
1. The relinquished property must have been owned by the taxpayer for at least two years preceding the exchange. The replacement property must be owned by the taxpayer for at least two years following the exchange.
2. During each two year period the taxpayer must rent the property to third parties at fair market value for at least fourteen days each year.
3. During each two year period the taxpayer’s personal use of the property must not exceed the greater of fourteen days each year or ten percent of the number of days rented each year.
Any safe harbor guidance from the IRS on tax-deferred exchanges is welcome, and Rev. Proc. 2008-16 is no exception. Rev. Proc. 2008-16 will make tax-deferred exchanges of vacation homes more predictable, and therefore more attractive.
Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, unless specifically indicated otherwise, any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of avoiding tax related penalties or promoting, marketing or recommending to another party any tax related matter addressed herein.
The previous article in not intended to provide tax advise concerning this topic. Individuals should consult their tax professional to review their own personal tax circumstances.
Please contact Jonathan Bagg at 904.599.2028 for assistance with real estate services.