Converting an Investment to a Primary Residence
Many of our clients strategize to exchange investment rental property into
another new investment rental property, in a great location like the Outer Banks,
which they will eventually convert into a primary residence. This powerful tax
strategy takes planning but essentially converts investment property into a future
Section 121 of the Internal Revenue Code defines the tax treatment of our
primary residences when we sell them. Married couples filing jointly can exclude
up to $500,000 of gain when they sell their principal residence. Single
taxpayers can exclude up to $250,000 of their gain. To qualify for the exclusion,
you must have owned and used the home as a principal residence for an
aggregate of two years out of the five years before the sale. You can only have
one primary residence at a time; all other properties you own are either second
homes or investments. A full explanation of the exclusions can be found in IRS
Publication 523, Selling Your Home.
The strategy to exchange an investment rental for a new investment rental in a
location where we may wish to retire takes some planning but will maximize
your tax savings. When you exchange your current investment rental property
into a new investment rental property, you defer the tax you would normally
have to pay on the gain. This is reflected in the lower basis assigned to your
new replacement property.
When you sell your current principal residence, you exclude the gain up to the
Section 121 limits. Then, after you convert your replacement property into your
new principal residence, you become eligible once again for exclusion of up to
$250,000/$500,000 of gain after you have owned the replacement property for
five years and used it as a principal residence for two years. The five-year
ownership on a principal residence only applies to properties that have come to
you from an exchange. Tax will be due on gains above the Section 121 limits
and any depreciation taken after May 6, 1997.
If you just acquired a property by doing a like-kind exchange, you must hold the
new property as an investment, rental, or business property. No one can tell you
how long the exchange replacement property must be held in investment status
before you convert it to personal use, but most tax experts recommend not less
than one year. IRS issued Revenue Procedure 2008-16 which defines a safe
harbor and includes a two-year holding period of limited personal use and a
rental period if you want to be safe.
The current issue is that effective January 1, 2009, the IRS Section 121 was
changed. Before the President signed H.R. 3221, the Housing Assistance Tax
Act of 2008, on July 30, 2008, a revenue-raising provision first promoted by
Representative Charlie Rangel (D, N.Y.) was included by the conference
committee as Section 3092 of the bill. This provision is an amendment to
Section 121 and has a major impact on small landlords and taxpayers who were
planning to convert their rental or second home to a principal residence and
then exclude any gain from their income when they sell the property.
The term Period of Non-Qualified Use referenced in the amendment is very
important and means any period during which the property is not used as the
principal residence of the taxpayer, the taxpayer’s spouse, or a former spouse.
Importantly, the period before January 1, 2009, is excluded. In addition,
subsection (4)(C)(ii) of the amendment provides additional exceptions to Period
of Non-Qualified Use. These exceptions are (1) any portion of the five-year
period (as defined in Section 121(a)) which is after the last date that such
property is used as the principal residence of the taxpayer or spouse, (2) any
period not exceeding 10 years during which the military or foreign service
taxpayer, or spouse, is serving on qualified official extended duty as already
defined, and (3) any other period of temporary absence (not to exceed a total of
two years) due to change of employment, health conditions, or such other
unforeseen circumstances as may be specified by the HUD Secretary.
The amendment states “gain shall be allocated to periods of non-qualified use
based on the ratio which (i) the aggregate periods of non-qualified use during
the period such property was owned by the taxpayer, bears to (ii) the period such
property was owned by the taxpayer.”
How does this affect your second home planning? Suppose the married
taxpayer exchanged into an investment property and rented it for four years,
then moved into it and lived in it for two years. The taxpayer then sold the
residence and realized $300,000 of gain. Under prior law, the taxpayer would be
eligible for the full exclusion and would pay no tax.
Under the new law, the exclusion will have to be prorated as follows: four-sixths
(4 out of 6 years) of the gain, or $200,000, would be taxable and thus would be
ineligible for the exclusion. Two-sixths (2 out of 6 years) of the gain, or only
$100,000, would be eligible for the exclusion.
Importantly, non-qualified use prior to January 1, 2009, is not taken into account
in the allocation for the non-qualified use period but is taken account for the
ownership period. Thus, suppose the taxpayer had exchanged into the property
in 2007, and rented it for three years until 2010,and then converted the property
into a primary residence. If the taxpayer sold the residence in 2013, after three
years of primary residential use, only one year of rental, 2009, would be
considered in the allocation for the non-qualified use. Thus, only one-sixth (1
out of 6 years) of the gain would be ineligible for the exclusion.
In general, the allocation rules only apply to time periods prior to the conversion
into a principal residence and not to all time periods after the conversion out of
personal residence use. Thus, if a taxpayer converts a primary residence to a
rental and never moves back in but otherwise meets the two-out-of-five year test
under Section 121, the taxpayer is eligible for the full exclusion when the rental
is sold. This rule only applies to non-qualified use periods within the five-year
look-back period of Section 121(a) after the last date the property is used as a
This great tax strategy is still available, but Congress has created new rules, so it
is important taxpayers get good advice before making any moves.
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