RECENT FEDERAL TAX LAW CHANGES TO REAL ESTATE TRANSACTIONS

[This information does not constitute tax advice. Please consult your tax professional for specific tax

advice related to a specific transaction]

 

1. Property involved in a IRC Section 1031 exchange that is subsequently converted to a primary

personal residence needs to be held for at least five years as an additional qualification in order

to get the $250,000 IRC Section 121 exclusion for individuals (or $500,000 for married filing

joint). In other words, owners still need to meet the 2 of 5 rule and other rules, but the total

years of ownership needs to be at least five years.

 

2. Property that is a second home does not qualify as a primary personal residence (the taxpayer

can have only one at a time).

 

3. Property that is a primary personal residence potentially qualifies for the $250,000/$500,000

exclusion.

 

4. Property that is a second home Is a personal asset but does not qualify for the

$250,000/$500,000 exclusion. As a personal asset, a loss on sale is not deductible. As a personal

asset, it does not qualify as property eligible for an IRC Sec 1031 exchange if there is a gain.

 

5. The character of residential real estate can change if the usage changes (from/to Primary

personal residence/second home/investment/business property).

 

6. Taxpayers have converted rental property to a primary personal residence, lived in the property

for at least two years and then sold the property, excluding the resulting gain and using IRC

Section 121 to exclude $250,000/$500,000. Recapture of part or all of the rental depreciation as

ordinary income is still required before calculating the gain to be excluded. This option is still

available, however, a new law requires allocating the gain on the property sale between

qualified and non-qualified use. The gain allocated to the non-qualified use must be reported

while the gain allocated to the qualified gain is potentially excludable under IRC Section 121.

 

7. Taxpayers have acquired property in an IRC Section 1031 exchange, used the property as rental

property and later converted the property to a primary personal residence, lived in the property

for at least two years and then sold the property, excluding the resulting gain and using IRC

Section 121 to exclude $250,000/$500,000. Recapture of part or al/ of the rental depreciation as

ordinary income is still required before calculating the gain to be excluded. This option is still

available, however, a new law requires allocating the gain on the property sale between

qualified and non-qualified use. The gain allocated to the non-qualified use must be reported

while the gain allocated to the qualified gain is potentially excludable under IRC Section 121. In

addition, the property acquired in the IRC Section 1031 exchange and later sold needs to be held

for a total of five years and meet all of the other requirements in order to qualify for the Section

121 exclusion.

 

8. Generally the years used as a primary personal residence count as qualified use, and the years

used as rental property count as non-qualified use. For example, if a property has an $800,000

gain of which $100,000 is depreciation recapture, and the property has two years of qualified us

and five years of non-qualified use, the resulting tax effects would generally be as follows:

$100,000 would be reported as depreciation recapture income, and the remaining gain would be reported as follows. The qualified use of 2/7 X the total remaining gain of $700,000 or

$200,000 would be subject to the IRC Section 121 exclusion and the non-qualified use of 5/7 X

the total remaining gain of $700,000 or $500,000 would be reported as capital gain. A transition

rule provides that non-qualified use prior to January 1, 2009 is not taken into account and is

ignored for the revised IRC Section 121 exclusion calculation.

 

9. As usual, there are qualifiers and exceptions with the new laws, but the rules have generally

been tightened in the last few years making more of the gain on sale of residences taxable.

 

10. Taxpayers need to reassess their real estate holdings in view of the new rules.

• Since longer rental usage generally reduces the amount of gain available for IRC Section

121 exclusion, taxpayers may want to Increase their primary personal usage, cut their

rental use period and sell property while it is eligible for the maximum Section 121 exclusion.