The Housing Assistance Tax Act of 2008 was signed into law on July 30, 2008, and was designed to boost the floundering housing market by providing certain tax breaks for homeowners and homebuyers. The Act provided new property tax deductions for non-itemizers and offered first-time homebuyers credit for purchases. However, one of the most overlooked and unknown changes was the reduced home sale exclusion for years after 2008 for property used as both a principal residence and vacation/rental property.
The new law required homeowners to pay taxes on gains that reflect the portion of time the taxpayer owned a home when it was not used as a principal residence. The remaining gain was available for exclusion (up to $250,000 for single filers and $500,000 for joint-filers.) Previously, the 'loophole' allowed taxpayers owning a vacation or rental property to live there for two years, sell it, then take the full gain exclusion event though portions of their gain may have been attributable to when it was used as a vacation or second home, not as a principal residence.
So then what happens when a homeowner moves into an existing vacation or rental property after divorce?
The Housing Assistance Tax Act of 2008 provides four important tax law changes that impact individuals and small businesses. These tax laws are part of the larger Housing and Economic Recovery Act of 2008 (HR 3221, Public Law 110-289) which provides a number of laws relating to housing and mortgages. As mentioned previously, one of the highlighted tax law changes is related to prorated capital gains exclusion for real estate for periods of non-primary use. This may be a concern for divorcing clients when one spouse retains a current investment property to be used as their new primary residence.
Under the Housing Assistance Tax Act of 2008, the IRS now wants its share of the capital gains tax during the period from January 1, 2009, up until the property becomes a primary 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, 2018, for $400,000 and uses it as a rental property for two years, claiming $20,000 of depreciation. On January 1, 2020, John begins using the property as his principal residence. John moves out of the house and sells it for $700,000 on December 31, 2022. 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).
When an Investment Property Becomes the New Primary Residence
The Housing Act is intended to restrict gain exclusion when an investment property is transferred from a non-qualifying use to a principal residence, the new provisions do not restrict gain exclusion when a 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.
The moral of the story is that moving into a rental property a be primary residence may carry significant tax consequences and you should definitely discuss any tax concerns with your attorney or financial adivsor.
Working with a Certified Divorce Lending Professional (CDLP®) and incorporating Divorce Mortgage Planning into the divorce settlement may help both spouses obtain new mortgage financing post-divorce.
Contact a CDLP® today for a copy of the Divorcing your Mortgage Homeowner Workbook, a guide to credit, real property, and mortgage planning after divorce. This workbook will help you get organized, be prepared, and understand your mortgage financing position whether you are needing to refinance the marital home in an Equity Buy-Out situation or prepare to sell and purchase a new home post-divorce.
As a divorce mortgage planner, the CDLP® can help divorcing homeowners make a more informed decision regarding their home equity solutions while helping the professional divorce team identify any potential conflicts between the divorce settlement, home equity solutions as well as real property issues.
Divorce Mortgage Planning is the ability to put into play the desired outcome by pairing the needs and options available while helping to incorporate the necessary details and clarity into an executable settlement agreement to obtain closure and peace of mind successfully.
Working directly with the divorce team, a CDLP® incorporates divorce mortgage planning into the overall process with a unique and solid understanding of the intersection of family law, financing and tax planning, real property, and mortgage planning.
Involving a Certified Divorce Lending Professional (CDLP®) early in the divorce settlement process can help the divorcing homeowners set the stage for successful mortgage financing in the future.
This is for informational purposes only and not for the purpose of providing legal or tax advice. You should contact an attorney or tax professional to obtain legal and tax advice. Interest rates and fees are estimates provided for informational purposes only and are subject to market changes. This is not a commitment to lend. Rates change daily – call for current quotations.
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