Here's a tax alert for real estate investors who use popular tax-free exchanges: The recently signed federal housing legislation contains a hidden zinger that could cost you thousands of dollars if you don't plan around it.

As of next January 1st, investors who exchange into rental or second home properties that they later convert into their personal homes no longer will be eligible for the full $250,000 to $500,000 tax-free exclusions now available on sales of principal residences.

Instead, they'll need to allocate their time of ownership between taxable investment or second home usage and non-taxable principal residential usage.

To qualify for tax-free exclusions they'll still need to use a property as their primary home for two out of the five years preceding any sale or exchange. But if any part of their total usage time after January 1st is what the new law calls "nonqualified" -- that is, investment, rental or second home use - then that will lower their maximum exclusion.

This an especially big deal for investors using "Section 1031" exchanges because they frequently shield their real estate gains on rental houses and condos by moving into them for a couple of years and converting previously taxable gains into non-taxable principal residential profits.

Just how popular has that technique been in recent years? "Extremely popular," says tax-free exchange intermediary George Foss in Littleton, New Hampshire. "Many of my clients have used it because it's a way to totally shield yourself" from capital gains taxation.

Congress's new limitation of the strategy is "terrible in my opinion," said Foss in a discussion with Realty Times last week. "It's just rotten."

An example of the dollars and cents impact of the change was provided by the Federation of Exchange Accommodators, a national trade group representing investors and intermediaries. Under the old law, an investor could exchange into a property that he or she then rents out for three years. Then the investor would move in and use the property as a principal residence for two years.

When the investor -- who is single -- sold the house for a $300,000 gain, $250,000 of that amount would be tax-free under the old law.

Under the new law, three fifths of that gain -- $180,000 out of the $300,000 -- would be taxable, while just $120,000 would be tax free.

That $130,000 difference is why exchange investors are so upset with Congress's latest tax increase.

Published: August 15, 2008

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.