LOS ANGELES (MarketWatch) -- Many readers panicked after reading my previous column on how the Housing and Economic Recovery Act of 2008 will affect the personal residence exclusion ($250,000 for single filers; $500,000 for married filing jointly) on sales of vacation homes or former personal residences.
TaxMama's mailbox was inundated with questions about your specific situations. Whew! Too many to answer all of you personally. But, we selected four questions that represented the issues affecting most of you and took those questions to the experts. See previous column.
Move back in, or tax-free exchange?
Sofia writes: I own a home which I currently rent out. I have owned the house close to 30 years. I lived in it the first three years and rented it out the following 27 years. I am retired and presently live in a rented apartment. It was my understanding that I could move back in for two years and then sell it using my personal residence exclusion of $250,000. Or I could do a 1031 exchange to avoid some or all of the taxes. What advantage would there be if I moved back into this home before 2009 vs. doing a Section 1031 exchange in 2009?
In general, the experts agree that, at present, the house has been rented too long to qualify for the personal residence exclusion if Sofia were simply to sell it. Naturally, if she moves in now, in 2008, and sells it two years later, Sofia would be entitled to the full $250,000 since the new rules only apply to properties with "nonqualified use" starting Jan. 1, 2009. (We'll explain "nonqualified use" in a moment.)
But if moving back in is an inconvenience or costs Sofia an important stream of rental income, what about that tax-free exchange alternative?
Dan Yu, a certified financial planner and director at Eisner LLP's Personal Wealth Advisory division in New York, says that when you elect to use a 1031 exchange, you are deferring taxes on the gain from sale of an investment or business property by lowering the cost basis on your replacement property. Certain rules must be followed. (Deferring means that you're putting off paying the taxes until later.)
Essentially, Sofia could follow the rules and trade the property -- and keep trading it as long as she is alive -- and pay little or no taxes on the exchanges. (Beware of "boot" -- money received during the course of the exchange or when the buyer's funds pay your selling costs.)
Then, after Sofia's death, the property would get a stepped-up basis for her heirs. In other words, at date of death, the tax basis (value) of the property would jump up to fair market value, and no taxes would need to be paid on all those deferred gains.
Seems like a good idea? Sure. But there's a nearly forgotten provision of the Economic Growth and Tax Relief Reconciliation Act of 2001, warns Barbara Weltman, an attorney and author of J.K. Lasser's "Small Business Taxes 2008." That step-up in basis will disappear after Dec. 31, 2009.
We already moved back home
James writes: We recently moved back into our home after renting the property out for three years. Are you saying we are safe from the new law as long as we have moved back into the rental residence before the end of this year?
In a word, yes. All experts agree unanimously.
'Nonqualified use' reduces exclusion
Rajesh wants to know what the tax consequences would be for a home converted to a rental: I bought a home in October 2002. I stayed in the home until June 2006; then rented it from July 2006 onwards. What would happen if I sell the property in March 2009? Would I still get any benefit from the personal residence exclusion?
Now we come to the heart of the issue. What happens to someone who made plans relying on the tax laws to remain in place for the full five years from the date they bought their home?
Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill., tax publisher, is confident that the way to interpret this nonqualified use still includes the five-year look-back period for personal use of the home. First, let's check to see whether the five-year rule is met: Will Rajesh use the house for at least two years out of the last five years?
By March 2009, the house will have been rented for a total of 33 months (July 2006 to March 2009). In the last five years before the projected sale in March 2009, Rajesh will have lived in the house for 27 months (60 months minus 33 months), which is more than two years.
Next, remember that fraction described in the housing bill? The numerator is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer and the denominator is the period the taxpayer owned the property.
Luscombe interprets this situation as follows:
The fraction's numerator is: Nonqualified use = January 2009 to March 2009 = 3 months
The fraction's denominator is: Ownership (last five years) = April 2004 to March 2009 = 60 months
Three divided by 60 = 0.05, or 5%.
So Rajesh would only lose 5% of his $250,000 exclusion. He'd still get credit for $237,500 or $475,000 if he's married.
Recent switch from home to rental
Mark is upset about the lack of warning. He writes: I just moved into a new home and did not sell my previous personal residence, relying on being able to use that $250,000 personal residence exclusion when I sell the house in two years. The plan was to rent it out for two years while the market recovers a bit and sell it then. Now based on what you wrote I am getting the feeling that I would be hit by taxes that I did not factor in my decision when I entered in a lease with tenants. Had I known that I would be taxed, I would have put it up for sale right in the first place.
Whew. This is tough. If Mark just converted his home to a rental in July, and has a two- year lease, he is going to be affected deeply by the new law. Let's look at the formula, assuming two things: 1) He can sell the house at the end of the two-year lease in July 2010 and 2) he will have owned the house for four years by then.
Here's the equation in Mark's situation:
Nonqualified use = January 2009 to July 2010 = 19 months
Ownership (last five years) = August 2006 to July 2010 = 48 months
Nineteen divided by 48 = 0.3958, or 39.58%.
Mark will lose almost 40% of his residential exclusion.
So it's time to compare the profit that would arise from selling it now with the full residential exclusion to the potential profit two years from now with only 60% of the exclusion. Assuming Mark is married, 60% of the exclusion would still be worth $300,000. If the projected profit is less than that, he won't lose a thing.
Even if the profit is more than the residential rental exclusion, Mark will only pay tax at 15% on the capital gains and whatever the state tax rate will be, if the state complies with the housing bill. Remember, not all states will comply with federal tax laws. Find out if your state does.
Yu recommends that you keep detailed records of improvements and all activities that affect the basis of your property. Those records will reduce your profits if you find yourself exceeding the personal residence exclusion limits.
If you've moved out of your home and rented it out, Luscombe advises you to watch that five-year deadline carefully. Be sure you sell the property while you still have a full two years of personal residential use.
Weltman reminds us that all this advice is the experts' best interpretation of the Housing and Economic Recovery Act of 2008. Until we see written guidance from IRS, as with all things tax -- who knows?
And finally, Yu wants taxpayers to remember one thing: The ordinary income from the recapture of the depreciation of the rental will be taxed (maximum rate 25%) even if someone qualifies for the personal residence exclusion.
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Summary of Changes
Property Held For Rental or Investment First
Property held for investment purposes and then subsequently converted into a primary residence will be impacted the most under these legislative changes to Section 121.
The amount of time that the real property was held as investment property (non-qualified use) will no longer qualify for tax free exclusion under Section 121. Only the actual time that the real property was held and used as a primary residence (qualified use) will qualify for the tax free exclusion.
This will significantly affect those homeowners who had planned to move into investment property and convert its usage to their primary residence in order to take advantage of the 121 exclusion. The longer the real property was held for investment the greater the impact will be on the amount of capital gain that can be excluded from taxable income (i.e. the more capital gain that must be included in taxable income).
Property Held As Primary Residence First
The modifications made to Section 121 do not affect homeowners that move out of their primary residence and convert it to non-qualified use. The homeowner can still take the full amount of the 121 exclusion upon the sale of the property as long as they still qualify for the 121 exclusion.
In other words, a primary residence that is subsequently converted into investment property will still qualify for the tax free exclusion under Section 121 provided the property is sold no later than three (3) years after its conversion to investment property. The property will no longer qualify for the 121 exclusion once it has been held by the homeowner as investment property beyond the three (3) year window.
