New rules seek to reduce tax advantages of converting second home to principal residence.

• Author: Rose, Kevin

On July 30, 2008, the 2008 Housing and Economic Recovery Act, P.L. 110-289, was signed into law by President Bush. While the act was principally aimed at strengthening the ailing housing market and injecting confidence into its related government-sponsored enterprises, it did contain some noteworthy tax provisions, which largely targeted homeowners, creditors, and state and local authorities.

Because the roughly $16 billion tax arm of this housing relief package was intended to be revenue neutral, the act includes a few significant revenue offsets, one of which seeks to close, at a projected cost to taxpayers of $1.4 billion over the next 10 years, a long-standing loophole previously available to homeowners with multiple residences.

Exclusion on Sale of Primary Residence

Under Sec. 121, a taxpayer can exclude up to $250,000 ($500,000 if married filing jointly) from gross income on the sale or exchange of his or her principal residence provided the taxpayer owned and occupied the property as his or her principal residence for an aggregate two-year period during the five-year period ending on the date of the sale or exchange. The exclusion is available for repeated use over a taxpayer's lifetime but typically, excluding certain exceptions such as a change in place of employment, health, or unforeseen circumstances, it cannot be used more than once every two years.

Before the passage of this most recent legislation, taxpayers who concurrently owned one or more residences and who, at some point in the future, intended to convert a home other than their existing primary residence into their primary residence had the opportunity to exclude $250,000/$500,000 of gain from income on the ultimate disposition of these residences, provided that the ownership and use time requirements of Sec. 121(a) were satisfied. The maximum exclusion was available to these taxpayers despite the nature of the prior use of the second residence as a rental property, an investment property, a vacation property, or property used in a trade or business.

Periods of Nonqualified Use Will Trigger Gain Recognition

With the passage of the Housing and Economic Recovery Act, beginning January 1, 2009, the full $250,000/ $500,000 exclusion under Sec. 121 will no longer be available on the sale of a taxpayer's principal residence if the residence was subject to nonqualifying use prior to its ultimate disposition (Sec. 121(b)(4)(A)).

Definition of nonqualifying use: For purposes of determining the amount of the Sec. 121 exclusion, a period of nonqualifying use is defined as "any period during which the property is not used as the principal residence of the taxpayer" (Sec. 121(b)(4)(C)). For example...