There may be a widely overlooked tax consequence for divorcing couples who own an investment property and move into it as their new primary residence. The Housing Assistance Tax Act of 2008 introduces critical tax law changes impacting individuals and small businesses. These laws are part of the broader Housing and Economic Recovery Act of 2008 (HR 3221, Public Law 110-289), which includes numerous housing and mortgage-related provisions.
Key Tax Law Change: Prorated Capital Gains Exclusion for Periods of Non-Primary Use
A significant tax law change under the Housing Assistance Tax Act of 2008 concerns the prorated capital gains exclusion for real estate during periods of non-primary use. This is especially relevant for divorcing clients when one spouse retains an investment property as their new primary residence.
The IRS requires its share of the capital gains tax from January 1, 2009, until the property becomes a primary residence.
Calculating Potential Tax Liability
After December 31, 2008, gains from the sale of a principal residence will not be excluded from income if the property was used for non-qualified use, as defined under Code § 121(b)(4), amended by Housing Act § 3092. This restriction applies only to non-qualified uses occurring after December 31, 2008. Non-qualified use includes any period after December 31, 2008, when the property is not the taxpayer's principal residence.
To calculate the gain allocated to periods of non-qualified use, multiply the total gain by the fraction of the aggregate periods of non-qualified use divided by the period the taxpayer owned the property. Non-qualified use does not include any portion of the five-year period after the last date the property was the taxpayer's principal residence.
Example Calculation:
John buys a home on January 1, 2014, for $400,000 and rents it out for two years, claiming $20,000 of depreciation. On January 1, 2016, John makes it his principal residence. He sells it for $700,000 on January 1, 2019. John used the property for non-qualifying use for the first two years. The year after he moved out is treated as qualifying use. Therefore, 40% (two out of five years), or $120,000, of John's $300,000 gain is not eligible for exclusion. The remaining $180,000 may be excluded. Additionally, John must include $20,000 of the gain attributable to depreciation as ordinary income (unrecaptured Code § 1250 gain).
Non-qualified use does not include periods when the taxpayer or spouse is on qualified official extended duty (up to 10 years) or any temporary absence due to employment change, health conditions, or other unforeseen circumstances (up to two years).
When an Investment Property Becomes the New Primary Residence
The Housing Act restricts gain exclusion when an investment property transitions from non-qualifying use to a principal residence. However, it does not restrict gain exclusion when a property transitions from a principal residence to non-qualifying use. This provision applies only to non-qualified uses beginning January 1, 2009.
Conclusion: Understanding Tax Consequences
Moving into a rental property as a primary residence can carry significant tax consequences. Working with an experienced mortgage professional specializing in divorcing clients is crucial. A Certified Divorce Lending Professional (CDLP®) can help answer questions and provide excellent advice.
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