New Limit On Home Sale Exclusion
Internal Revenue Code section 121 allows taxpayers to exclude up to $500,000 (on a joint return) of gain from the sale of a principal residence. To qualify, the taxpayer must have used the residence as the taxpayer’s principal residence for at least two of the five years immediately preceding the sale. The Housing Assistance Tax Act of 2008 has enacted a new limitation on the exclusion. That’s the law that the President signed on July 30 which also creates a new interest-free downpayment assistance loan of up to $7,500 for first-time homebuyers. Our summary of the new law is here: CALT Legal Brief - President Signs Housing Assistance Bill - New Tax Provisions.pdf
Note: Remember, the President had threatened to veto the bill, but the Democrats in the Congress had enough votes to override any veto so the President signed the bill.
New I.R.C. §121(b)(4) provides that if a residence was at any time not used as a principal residence of the taxpayer, the portion of the gain allocated to periods of “nonqualified use” is not eligible for the exclusion. That means, for example, if a taxpayer rented out a residence or used it only as a vacation home for a period of time, but still otherwise used it as the taxpayer’s principal residence for the required two out of five years preceding the sale, the full exclusion may not be available. In that instance, the portion of the gain eligible for the exclusion is determined by multiplying the gain on sale by a fraction. The fraction is as follows:
Period of time residence used as principal residence
Entire period of ownership
The numerator does not include any period of time before January 1, 2009, but periods before January 1, 2009, are included in the denominator. Also, the numerator does not include any time period of “nonqualified use” arising in the prior five years before the sale that occur after use as a principal residence, and does not include up to 10 years of nonqualified use due to the taxpayer’s service as a member of the uniformed services, foreign service or as an employee of the intelligence community. In addition, the numerator does not include up to two years of nonqualified use due to change in employment, health conditions or any other unforeseen circumstances.
So, if the gain triggered on sale of a principal residence is large enough and a small enough portion is allocated to nonqualified use, the remaining gain may still be fully excludible. That’s likely to benefit only the very wealthy who own expensive homes. They will still be able, within limits, to rent out their mansions or use them as vacation homes and use the gain exclusion provision to its fullest extent. However, for lower value homes owned by taxpayers with more modest incomes, the new rule will more likely come into play in limiting the gain exclusion. For example, if the taxpayer sells a home for $2,000,000 that has an income tax basis of $1,000,000, and 20 percent of the $1,000,000 gain is allocated to periods of nonqualified use, $800,000 is still available for the exclusion. Since the exclusion is capped at $500,000 on a joint return and ($250,000) on a single return, the full amount of the exclusion is still available. So, for wealthy taxpayers, the new rules may not actually result in any additional tax. On the other hand, if a taxpayer with more modest income sells a home for $200,000 with a tax basis of $150,000, and 20 percent of the $50,000 gain is allocated to periods of nonqualified use, only $40,000 of the gain is eligible for the exclusion. So, the new rules work to increase the taxpayer’s tax liability by $1,500 (assuming a 15 percent applicable capital gain tax rate).