Existing Rental Property as Primary Residence After Divorce

Divorcing couples who own investment properties and plan to move into a rental home as their new primary residence should be aware of potential tax consequences. The Housing Assistance Tax Act of 2008 introduces significant tax law changes that can impact these individuals.

Key Tax Law Changes from the Housing Assistance Tax Act of 2008

The Housing Assistance Tax Act of 2008 is part of the broader Housing and Economic Recovery Act of 2008 (HR 3221, Public Law 110-289), which addresses various housing and mortgage-related issues. One of the critical changes concerns the prorated capital gains exclusion for real estate used for non-primary purposes. This change is especially relevant for divorcing clients when one spouse retains an investment property to use as their new primary residence.

Pro-Rated Capital Gains Exclusion

Under the Housing Assistance Tax Act of 2008, the IRS requires the payment of capital gains tax on the period from January 1, 2009, until the property becomes a primary residence. Here’s how to calculate the potential tax liability:

Calculating 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 nonqualified use. According to Code § 121(b)(4), as amended by Housing Act § 3092, a nonqualified use is any period after December 31, 2008, during which the property is not the taxpayer's principal residence.

To determine the gain allocated to periods of nonqualified use, multiply the total gain by the fraction representing the aggregate periods of nonqualified use divided by the total ownership period. Note that nonqualified use does not include any part of the five-year period after the property was last used as the principal residence.

Example Calculation:

John buys a home on January 1, 2016, for $400,000 and rents it for two years, claiming $20,000 of depreciation.
On January 1, 2019, John makes it his principal residence.
John sells the home for $700,000 on January 1, 2022.

John’s non-qualifying use was 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 gain of $180,000 can be excluded. Additionally, John must include $20,000 attributable to depreciation as ordinary income.

Exceptions to Nonqualified Use

Nonqualified use does not include:

Any period when the taxpayer or spouse is on qualified official extended duty (up to 10 years).
Temporary absences due to employment change, health issues, or other unforeseen circumstances specified by the IRS (up to two years).

The Housing Act’s provisions apply only to nonqualified uses beginning January 1, 2009. They do not affect gain exclusion when property transfers from a principal residence to a non-qualifying use.

Importance of Working with a Certified Divorce Lending Professional (CDLP®)

Navigating the complexities of tax laws and mortgage financing during a divorce can be challenging. A Certified Divorce Lending Professional (CDLP®) specializes in working with divorcing homeowners and can provide invaluable advice on these matters. They can help you understand the implications of the Housing Assistance Tax Act of 2008 and ensure that you make informed decisions regarding your real estate and mortgage options.

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