When Congress passed the Housing Assistance Act of 2008 a few months ago, their goal was to help those people who were losing their homes in foreclosure. One of the side affects of the bill, however, was a change that could effect taxation on the gain from the sale of your personal residence.

IRS law excludes $250,000 of the gain from taxation if you're single, and $500,000 if you're married, when you sell a primary residence you've lived in for at least two years of the last five years. This is so even if a portion of the gain was rolled over into the property in a 1031 exchange transaction.

For example, if you and your spouse sold a rental property in Kansas, and bought a property in Vail, Colorado, rented it out for several years, and then moved into it as your primary residence for a couple of years, your excluded gain when you sell the Vail house could include gain that was rolled into it in your exchange.

The new law modifies that rule and penalizes you for time that your property is not your primary residence; you have to prorate the gain between the periods the property was not your primary residence, and the periods that it was. (Your primary residence is the place you live; the address you use on your drivers license; where you're registered to vote, etc.)

Only the non-residence period after January 1, 2009 is excluded. So, if you bought, or exchanged into, a property on January 1, 2007, rented it for three years, moved into it on December 31, 2009, then lived in it for 3 years until you sold it, you would have owned the property for 6 years, during which it was a rental for 3 and your residence for 3. However, since only one of the rental years was after January 1, 2009, the numerator in your calculation would be one (the number of rental or non-residence years after January 1, 2009), and your denominator would be 6 (the total number of years you owned the property). In other words, 1/6 of your gain would be taxable; if your total gain was $300,000, then $50,000 of that would be taxable, even though you would otherwise be entitled to an exclusion of $500,000.

I talk about the non-residence period rather than the rental period because it's not necessary that you actually rent the property – the law deals with the periods that the property is your residence, versus the periods that it is not. In my example above, if the Vail property had been your vacation home, instead of a rental, for the three years before you moved into it, and then your residence for the next three years, the result would have been exactly the same: $50,000 of the gain would be taxable out of a total gain of $300,000.

The new law only covers those situations where the period when the property was a rental or vacation home falls before it becomes your primary residence. It does not cover situations where it was your residence first, and then became a rental property – this was done so that homeowners who were forced to rent their former residence while they tried to sell it would not be penalized.

As time goes on, we'll have lots of questions about this new law that will have to be answered by court cases or IRS rulings (such as what happens if you build a house on a piece of bare land that you've owned for years?), but my advice is that if you are planning to move into your current rental or vacation property at some point in the future, you should do so as soon possible.

Published: January 14, 2009

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Gary Gorman is a retired CPA who has taught national tax classes for both Arthur Andersen & Co. and for Price Waterhouse & Co. and numerous undergraduate tax classes at Oregon State University. Since 1994 he has educated realtors, investors, CPAs and attorneys throughout the United States and Mexico on the intricacies of 1031 Exchanges. As the author of the best selling 1031 book Exchanging Up! and a co-author with Rich Dad/Poor Dad and Donald Trump, Gary is considered one of the Nation's leading 1031 Experts. Gary is the owner and managing partner of the national firm, 1031 Exchange Experts, LLC, which headquarters is located in Denver, Colorado, and offices in Arizona, Connecticut, Florida, Hawaii, and Texas. His firm is commited to securely holding client funds in separate, segregated accounts which clients can monitor through our affiliate banks' website. As a Qualified Intermediary, Gary has been involved in more than 30,000 1031 Exchange transactions since 1994. Contact him at , visit his website at expert1031.com, or call 866-694-0204.