As estate planning attorneys, many clients come to us for an estate plan, including a living trust and ancillary documents.  Frequently, when they explain their situation, we are able to assist them in ways that they did not contemplate.  What follows is one example.

Currently Internal Revenue Code Section 121 provides an exclusion from the sale of the taxpayer’s principal residence up to $250,000 of gain ($500,000 for a married couple filing a joint return) as long as the residence was the principal residence for 2 or more years out of the 5 year period ending on the date of sale.  Moreover, the exclusion may be used once every 2 years.

Besides individuals, the exclusion may be used by: (1) the estate of a decedent; (2) any individual who acquired the home from the decedent within the meaning of IRC Section 1022 (which deals with the treatment of property acquired from a decedent dying after December 31, 2009); and (3) a trust which was a qualified revocable trust immediately before the death of the decedent.

This summer Congress passed the “Housing and Economic Recovery Act of 2008” which primarily is concerned with the increase in foreclosures and other concerns in the housing market. However,  it also amends section 121.  Beginning this coming January, “gains shall be allocated to periods of non-qualified use.”  What this means is that the exclusion amount will now be adjusted to deal with periods where the property is used as a second home or rental property. 

Here is how it will work beginning January 1:  if a homeowner uses a home as a rental property for the first three years of the five year period and then uses the home as a primary residence for the next two years, the homeowner will only be able to exclude 40% (2/5) of the gain.

The IRS will only look at January 1, 2009 and thereafter.  Any non-qualified uses prior to that time are exempt.  Moreover, if the homeowner first uses the home as a primary residence and then converts it to a rental property in or after year three, there should not be proration. 

Do not rely on the above.  It  is always wise to talk to your tax preparer or an estate planning attorney prior to engaging in any acts that might decrease the capital gain tax exclusion.  In certain circumstances, the taxpayer may still be able to utilize Internal Revenue Code Section 1031 (Exchange of Property Held for Productive Use or Investment).