Home Gain Exclusion Restricted

Reduced for periods of nonqualified use

By Kaye A. Thomas
Posted August 5, 2008

Provision applies to nonqualified use after 2008.

The housing law signed by President Bush on July 30 places a new restriction on the $250,000 exclusion allowed on gain from the sale of a principal residence. If there is a period of "nonqualified use" after 2008, the portion of your gain allocated to that period won't qualify for the exclusion. The provision will primarily affect people who own vacation homes or rental properties but convert them to a principal residence for a period of at least two years prior to sale.

Example: You've owned a vacation home for many years and would like to sell it. You expect to have a gain of $350,000, and the entire gain would be taxable because you haven't used the property as your principal residence. Rather than sell it now, you and your spouse make this home your principal residence for a period of two years, after which you sell it for a gain of $400,000. The home now qualifies as a principal residence.

Previously, this arrangement would make it possible to exclude all the gain because you're allowed an exclusion of up to $500,000 on a joint return. (A recapture rule applies to depreciation deductions, but in this example you didn't claim any depreciation.) Under the new law, part of your gain would be taxable, but only to the extent you have nonqualified use of the property after 2008.

Nonqualified use

Generally you're treated as having qualified use during any period you, your spouse or your former spouse use the property as a principal residence. All other time is treated as a period of nonqualified use, regardless of how the property is being used, or even if it is not being used at all. There are some helpful rules here, though.

Nonqualified use before January 1, 2009 doesn't count.
Nonqualified use occurring after your last use of the property as a principal residence doesn't count. For example, if you accept a job transfer to a new city and you aren't able to sell your old home until two years after you move out, those two years won't count as nonqualified use.
A period of "qualified official extended duty" for someone in the uniformed services, foreign service or intelligence community doesn't count as nonqualified use.
A period of temporary absence (up to two years) due to change of employment, health conditions or (to the extent specified by the IRS) other unforeseen circumstances doesn't count as nonqualified use.

Gain allocated to nonqualified use

To determine the amount of gain allocated to a period of nonqualified use divide the amount of time the property had nonqualified use by the total amount of time you owned the property. This means we don't have to (and aren't allowed to) determine this based on the actual change in value of the property during the relevant periods.

Example: You buy a home in 2009 and own it as a vacation home for eight years. After that you make it your principal residence for two years and sell it for a gain of $150,000. Of the ten years you owned the property, eight years were nonqualified use, so 80% of the gain doesn't qualify for the exclusion. You get to exclude only $30,000 of the gain, even if most of the appreciation happened as a result of a sudden jump in value after you started using the home as a principal residence.

Depreciation

If you claimed depreciation deductions after May 6, 1997, a rule that was previously in place prevents you from applying the exclusion to that portion of your gain. This rule continues to apply, and it applies before the new rule for nonqualified use. Only the amount of gain remaining after application of the old rule for depreciation is allocated under the new rule for nonqualified use. Here's an example adapted from a congressional committee report:

Example: You buy a home in 2009 for $400,000 and use it as a rental property for two years, claiming $20,000 of depreciation deductions. After that you use it as a principal residence for two years. Then you move out and, a year later, sell the property for $700,000.

Your gain on this sale is $320,000, the difference between the $700,000 selling price and your basis of $380,000. (Your original basis of $400,000 was reduced by the $20,000 depreciation deductions.) We apply the depreciation rule first, and that rule requires you to pay tax on $20,000 of the gain.

That leaves $300,000 of gain that can be allocated under the new rule. You owned the property five years: two years as a rental property, two years as your principal residence and one year after you stopped using it as a principal residence but before you sold it. Because of the special rule described above (second bullet point), the last year doesn't count as nonqualified use, even though you didn't live in the home that year. It still counts as a year of ownership, though, so your nonqualified use is two years divided by five years, or 40%. You get to exclude 60% of the $300,000, or $180,000. You have to report taxable gain of $140,000, including $20,000 from the depreciation rule and $120,000 from the rule for nonqualified use.