Converting Your Property From Rental To Residence

We haven't been thinking of 1031 exchanges so much in the recent past, but even now, properties ARE selling, so if you've got a move underway, here are 2009 1031 exchange laws you should know about if you're considering moving into your income property and later taking the capital gains exemption as a principal residence.

The Housing Assistance Tax Act of 2008 changed what is known as Section 121 of the Tax Code:
As of January 1, 2009, exclusion must be allocated between the period the principal residence was used as an investment property or second home, and the period of time the residence was used as your principal residence. Any portion of the exclusion amount allocated to the period the property is not used as your principal residence is eliminated.

Suppose you exchange into a rental property which is rented for four (4) years, and then move into this former property and live in it for two (2) years as a principal residence. Then you sell the principal residence and realize $300,000 of gain. Under prior tax law, the you would be eligible for the full $250,000 exclusion and would pay tax on the $50,000 remainder.

Under the new law, the exclusion is prorated as follows (Note: This example does not take into account depreciation taken after May 1997, taxable at 25%):

Two-thirds (4 out of 6 years) of the gain, or $200,000, is ineligible for the $250,000 exclusion.
One-third (2 out of 6 years) of the gain, or $100,000, is eligible for exclusion. [This example was changed to show that the allocation formula takes into account years before the 5 year lookback period in §121(a).]

But, suppose you exchanged into the property in 2007, and rented for 3 years until 2010 prior to the conversion to a principal residence. If you sell the residence in 2013, after three years as a principal residence, only the 2009 rental period 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 §121 tax exclusion.

So, if you're thinking of property conversion, be sure to check with your accountant or tax preparer about your actual exclusions allowed on your return!