It's almost that time again, you know the end of the year and all of the changes that come with it. We had our first snow here in Summit County Colorado last week. In fact it was flurrying when I got to the office this morning. I began to think about the coming winter, the ski season and realized Christmas and the New Year are just a few short months away.
I had a couple that I showed vacation homes to this weekend and after thinking about them and the rapidly approaching new year I was reminded about all the questions they had in relation to buying their first second home / investment property. They began to ask me many questions which invariably led to 1031 exchanges.
I realized that I had not yet done an update to our blog about the changes coming to 1031 exchanges for the 2009 year. Our blog has previously covered 1031 exchanges (see How to do a 1031 exchange) so we will not deal with the entire 1031 process in this entry but focus on new changes that may impact you for 2009.
An owner of a property would typically use a 1031 exchange to defer gains and other tax payments upon the sale of an investment property. To defer these taxes, the seller of an investment property buys a replacement property of equal or higher value.
The seller has to satisfy timing requirements and other rules, but if those are met, he or she is able to sell an existing investment property and then buy a new property without having to pay the IRS any taxes. One of these requirements is that the new property purchased must be used for investment purposes.
for 2009 there is a new limit on excluding a gain when converting an investment property to a primary residence.
The Housing Assistance Tax Act of 2008 signed by President Bush and pushed by congress became law on July 30, 2008. It includes a provision which limits the amount of gain that can be excluded when you sell a house used as a primary residence if you also used the house for another purpose, such as a rental.
Under the rules of Section 121 of the Internal Revenue Code, you will not owe capital gain taxes up to $250,000 of gain, or $500,000 of gain if you are married and filing jointly, when you sell a house used as a primary residence for two of the previous five years. The two year period does not need to be consecutive to qualify for the exclusion.
Under the new law and as of January 1, 2009, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced by pro-ration by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.
Ok, lets try to make all that easy to understand by using an example in the real world. A coup
le that is maried uses a 1031 tax deferred exchange to acquire a house for $500,000 they plan to use as a rental in 2009. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple decides to sell the property at the end of the sixth year for 1 million dollars, netting a total gain of $500,000. Under the new rules, instead of being able to exclude the entire $500,000, the couple will not be able to exclude some of the gain based on how many years they used the home as a rental. Since they rented it for three years out of six, 50% of the gain, or $250,000, will not be able to be excluded from their tax liability. Because of this new limitation, the couple will be able to exclude $250,000 of the gain rather than the entire $500,000 under the rules before 2009.
There are several exceptions to this new restriction that I believe buyers and investors today must know. Any periods where the property is used other than as a primary residence that occurs prior to January 1, 2009 will not reduce the excludeable gain. Using the example above, if the three year rental period occurs prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000. In other Words if you have a second home now and plan on using it as a primary residence in the near future you may want to consider doing so before January 1, 2009.
Another important exception is that property that is first used as a primary residence and later converted to investment property will not be affected by this new law. For example, you own and live in a house for 18 years. Subsequently, you move out and rent the house for two years before
selling it. Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 20 year ownership of the property can be excluded, up to $250,000, or $500,000 if you are married and filing jointly.
As always consult your tax or legal professional for advice related to investment properties. But these new rules will give you something to think about before the new year.
Jason and Deanna are real estate brokers in Summit County Colorado with a focus on second and investment properties in the resort region. See our free MLS search for Colorado resort properties.
This is an interesting new law. I am wondering if you can decipher how the new laws will interpret the following situations, subject to your claim that "important exception is that property that is first used as a primary residence and later converted to investment property will not be affected by this new law":
How about properties that are converted multiple times from and to investment properties but have a first use of primary residence?
In particular, I purchased a condominium in 2000, lived in it until 2002, and have rented it out since. At this time, I plan to move back on or around 2025 (sale of primary residence & retirement) and sell it on or around 2027.
Also, I have another condominium purchased in 1996. It was lived in for only one year before becoming a rental. In 2007, it was traded in for a house via a 1031 exchange, that is also rented out. I plan to move into it on or around 2027 and sell on or around 2029.
Under current law, how will capital gains taxes be calculated on these properties? I expect both total gains to be less than 500k.
Thank you
Nick K
Nick, stimulating thought I love it.
Based on my interpretation of first use law the, the first scenario I believe would be qualified becuse it was a primary residence for 2 years before January 1, 2009 and is not effected by the new law in any way. However the burden of proof is always on us so make sure you have documentation to support the 2 years it was your primary residence.
In the second scenario the home that you currently own and use as a rental has never been your primary residence and even if it was for only a year the qualifying use (2 years out of 5) has to be prior to January 1, 2009 or it must be currently ongoing as of January 1, 2009. However if you were to move into the unit now and establish it as your primary residence before the new year my understanding is you should be ok due to the qualifying use started before the new law is in effect and it has provision for that.
As for capital gains calculations it depends. In your first senario my understanding any gain less than $250,000 single or $500,000 filing jointly would be excluded as long as you have not taken this exemption on another home within the last 2 years before the sale of the curreent home you want to exclude. Under the second scenerio capitol gains tax will apply if not using the 1031 exchange.
The percentage of capital gains tax will depend on several factors.
If you own a capital asset (home) for more than one year (1 year and a day) and then sell that home before January 1, 2011, the maximum capital gains tax rate that will be paid on the gain from that sale will be 15%. Note watch out for the alternative minimum tax or AMT which can increase the rate to 25%
If your tax bracket is in either the 10% or 15% income tax bracket based on your other sources of income excluding capital gains, then the capital gains tax rate on the above sale may be only 5%. However if your home was a depreciable real estate asset and depreciation had been claimed, the tax on the recapture of previously claimed depreciation is taxed at 25%. So the amount you depreciated over the years is taxed at 25% and the amount that has not been depreciated is based on the rules above.
All this may change because as of January 1, 2011 the capital gains rate is set to return to 45% and congress needs to act before then to stop the change. Lets all hope they do. Remember your entire finacial situation needs to be closely considered so talking to a good CPA is a must as they can help you with your entire picture.
Hope this helps
I am going to take this all as good knowledge. I have a basic grasp on it but I definitely would advise my clients to talk to their CPA as always.
We are glad to have the information. Thanks - we will bookmark and read carefully. Over the years, 1031 exchanges have been beneficial for us as well as for our clients. We always pass the information on to our CPA, too. Thanks!