New Section 121 Rules Begin to Bite

By:  George E. Foss III

As the days and weeks pass, the effectiveness (from IRS’ perspective) of the new provisions slipped into Section 121 grow and grow.

It used to be true that you could move into one of your rental properties, live there for two more years as your primary residence, and then sell the place and exclude $250,000 of the capital gain ($500,000 married.)

The first “chink” came in October, 2004, when Congress enacted Sen. Grassley’s amendment.  This states that to be able to claim the exclusions above, you have to own a property for five (5) years and live in it as your primary residence for the last two (2), unless you purchased the place with your own money.  No longer could a taxpayer take a residential rental as an exchange property and sell it any sooner.

Since the Amendment did not significantly lengthen the time a taxpayer would need to fully qualify for full Section 121 treatment (it extended the necessary time from four (4) to five (5) years, the industry just shrugged.

However, the next “chink” came at the end of July, 2008, when Congress passed the “Housing Bill,” and its infamous Charles Rangle Earmark.  From January 1, 2009 on, owners of rental properties (and vacation homes) would carry around an ever increasing fraction of “Non-Qualified Use” periods; the size of the fraction is the capital gain you pay tax on, no matter what.

Both the denominator and the numerator of this fraction change every month.

The denominator of the fraction is the number of months you have owned the property, for any purpose.

The numerator of the fraction is the number of months since January 1, 2009 that the property was NOT your principal residence.

Imagine, for example, a couple who rent in the city and own a getaway place in the country that they hope to eventually retire to.  Cong. Rangle himself probably falls into this category, but I digress.

The new rule really hurts these people, because after many years of non-primary residential use, the numerator and the denominator of the fraction are virtually identical, meaning that any gains they eventually realize on the sale of their property, even if they live there for two (2) years, will be almost all tax; no exclusions for them, or greatly diminished ones if any.

I have attached a chart (Click here) to this post which shows the results for various holding periods and various periods of non-primary residential use. Look at Row 10, Column 12: This is the percentage of tax (83%, no matter what) to be paid by someone owning a property for 12 years, and moving into it after Year 10.

It’s too bad that there were no hearings on this proposal, because it would have become pretty clear that the effects of the change were aimed an a completely unsuspecting group of city-dwelling, second home owners.

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