Change in Owner Occupied Capital Gains

Does anyone have any information about this new change in the law regarding owner occupied capital gains excemption? The one about the excemption being pro-rated if you move into a rental and sell it as owner occupied?

All I’ve seen is a little blurb on it that sounded like it only applies to properties purchased after the first of the year 2009.

I hope so, or there goes my exit strategy. I’m already moving into a rental, intending to sell it in 2 years. But 100% of the gains have occurred while it was a rental, and I don’t expect a huge increase in value over the next two years.

I’m going to be very unhappy if I can’t get any tax free gain on it when I sell.

The changes you refer to were part of the Housing and Economic Recovery Act of 2008 which applies to property sales beginning in 2009, regardless of the acquisition date.

Congress has decided to change the Section 121 capital gains exclusion rules for homeowners who have converted their investment property, vacation home, or second home to a primary residence in expectation that the entire gain on the sale will qualify for the capital gains exclusion.

Prior to this new legislation, each eligible taxpayer qualified for the $250K maximum capital gains exclusion on the sale of a primary residence if s/he had both owned and occupied the property as a primary residence for two of the five years prior to sale regardless of any prior periods of investment use. Under the new legislation, the two year ownership and occupancy tests still have to be met, but the capital gains realized on the sale will be allocated between periods of primary residence use and periods of “non-qualified use” over the entire ownership period. Second home use, vacation home use, rental or investment property use, or use in a trade or business are all examples of “non-qualified use.”

The capital gain allocated to periods of non-qualified use occurring in 2009 or later does not qualify for the Section 121 capital gains exclusion

Apparently, these changes do not apply to the homeowners who originally acquired their property for use as a primary residence, then later converted it to rental property prior to sale, yet still qualify for the Section 121 capital gains exclusion.

Because I am not in a situation where I have converted a rental to a primary residence, I did not really pay close attention to the new legislation and my understanding or interpretation of these rule changes could be imperfect.

Under this new legislation, you don’t track the annual increases or decreases in property value. Instead you calculate your capital gain and average that over your entire period of ownership. The average gain earned in years of non-qualified use are not eligible for the Section 121 tax treatment.

For example, you purchase a rental property for $100K and use it as a rental for three years. You decide to move into the property and occupy it as your primary residence for the next seven years. At the end of your tenth year of ownership, you decide to sell the house and move into another primary residence.

Your net sale price is $200K, giving you a $100K capital gain from appreciation. Since you owned the property ten years, you allocate $10K of your capital gain to each year of your ownership. $30K of your capital gain is allocated to the three years that you used the property as a rental, and $70K is allocated to the years of your primary residence use.

Since you owned and occupied the property as your primary residence for two of the five years prior to sale, you qualify for the Section 121 capital gains exclusion. In this example, only $70K of your capital gain qualifies for the exclusion. The remaining $30K is a taxable capital gain.

Don’t forget that unrecaptured depreciation is still taxed at 25%.