Often times in a divorce situation, one party may decide to move into an existing rental/investment property they retain through the divorce settlement and make the rental property their new primary residence. Makes sense when you need to find new housing anyway! It is important to recognize; however, there may be a tax consequence for doing so and you should speak with a tax account first.
The Housing Assistance Tax Act of 2008 is the tax act that potentially creates a capital gain tax when a property owner moves into an existing rental property as their primary residence and then sells at a later date. One of the most disadvantageous provisions in the Housing Act is the restriction of the capital gain exclusion upon the future sale. Under current law, a taxpayer can exclude up to $250,000 in capital gain ($500,000 for married couples) from the sale of a residence if the taxpayer has both owned and used the home as the taxpayer’s principal residence for at least two of the five years before the sale. Thus, a taxpayer could move into a non-qualifying property (in other words, vacation or rental property) and, after meeting the two-year residence requirement, sell the property and take advantage of the entire exclusion. The new restriction is intended to substantially restrict tax-free home sale gains for any taxpayer who benefits from the exclusion after he or she has converted a vacation home or rental property to his or her principal residence.
Calculating the Potential Tax Liability: After December 31, 2008, gain from the sale of a principal residence will not be excluded from income to the extent the property was used for a non-qualified use, as defined under Code § 121(b)(4), as amended by Housing Act § 3092. This new restriction only applies to non-qualified uses occurring after December 31, 2008. A non-qualified use consists of any period, beginning after December 31, 2008, in which the property is not used as the principal residence of the taxpayer.
To calculate the amount of gain that is allocated to periods of non-qualified use, the total amount of gain is multiplied by the following fraction: the aggregate periods of non-qualified use while the property was owned by the taxpayer divided by the period the taxpayer owned the property. Non-qualified use, however, does not include any portion of the five-year period that occurs after the last date the property is used as the principal residence of the taxpayer. For example, suppose John buys a home on January 1, 2009, for $400,000 and uses it as a rental property for two years, claiming $20,000 of depreciation. On January 1, 2011, John begins using the property as his principal residence. John moves out of the house and sells it for $700,000 on January 1, 2014. John used the property for a non-qualifying use for the first two years he owned it. The year after John moved out, however, is treated as a qualifying use. Therefore, 40% (two out of five years owned), or $120,000, of John’s $300,000 gain is not eligible for the exclusion. The balance of the gain, $180,000, may be excluded. In addition, John must include $20,000 of the gain attributable to depreciation as ordinary income (unrecaptured Code § 1250 gain).
Non-qualified use also does not include any period during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty (not to exceed an aggregate period of 10 years), nor does it include any other period of temporary absence because of change of employment, health conditions, or other unforeseen circumstances as may be specified by the IRS (not to exceed an aggregate period of two years).
The Housing Act is intended to restrict the use of the capital gain exclusion when the property is transferred from a non-qualifying use to a principal residence, so the new provisions do not restrict gain exclusion when the property is transferred from a principal residence to a non-qualifying use. Again, this provision only applies to non-qualified uses beginning January 1, 2009.
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Always work with a Certified Divorce Lending Professional (CDLP) when going through a divorce and real estate or mortgage financing is present.
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