Below is a great post from Kathleen explaining the change in the capital gains. This effects those who are taking investment property and converting it to owner occupant or the other way around.
The Housing Assitance Tax Act of 2008, enacted on July 30 modifies the rules with respect to gain on the sale of a primary residence. As you know, under prior law up to $250,000 of such gains ($500,000 for married coupels filing jointly) was excludable for purposes of capital gains tax if the taxpayer had owned and occupied the property as a principal residence for at least 2 out of the 5 years prior to the sale.
This meant that owners of investment properties could render them eligible for the primary residence exclusion in its entirety by moving into them for two years. Effective January 1, 2009, the exclusion will be restricted to the time the property is used as a principal residence (qualified use) for the period after that date. The gain allocable to the period of time the property is owned as an investment or a second home prior to its conversion to personal use will no longer be qualified (unqualified use) under the new exclusion rules. This does not, however, apply to years prior to 2009.
The effect is to prorate the exclusion on sales of investment or second homes converted to personal use after January 1, 2009. In other words, the exclusion will be reduced by the period of unqualified use taken as a the proportion of the total time of ownership. The period of ownership before January 1, 2009 is grandfathered (i.e., treated in effect as qualified).
For example, John Doe and his wife, Fanny, purchased a house as an investment in 2001 and rented it out. In January, 2006, they sell the house and do a 1031 exchange for a home in Phoenix where they intend to live when they are able to retire. In the meantime they will rent it out. In January, 2013, they retire from their jobs, sell their home in Peoria, and move to their house in Phoenix, which they remodel with some of the $300 thousand gain realized on their Peoria home (which is, of course, fully excludable from tax). After three years, however, they miss their friends and family and decide to move back to central Illinois. Suppose they realize a gain of $400 thousand on the sale, which closes in January 2016. Under the new rules, the four years from 2009 to 2013 would constitute "nonqualified use." The three years they occupy the property (2013-2015) as well as the period 2006 to 2009 are qualified. Thus the amount excludable would be calculated as: $400,000 less 4/10 X $400,000 or $160,000 =$240,000. Under this scenario, John and Fanny would be liable for capital gains tax on $160,000.
There is one further wrinkle. The new allocation rules (as between qualified and nonqualified uses) apply only to the period prior to conversion to principal residence. Owners who,for whatever reason, rent their residence after at least two years of occupancy are still eligible for the entire exclusion if they sell the property within the next three years.
So we as realtors need to be sure that our clients seek advice with their tax consultants!
