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New restrictions on sale of vacation and rental property conversions to "home" new 8/17/08

The Taxpayer Relief Act of 1997 amended Code § 121 to allow individuals to exclude gain realized on the sale or exchange of a principal residence from income up to $250,000 for individuals, or $500,000 on a joint return.

The Housing Assistance Tax Act of 2008 eliminates exclusion of gain from the sale of a principal residence allocable to periods during which none of taxpayer, taxpayer's spouse, or the taxpayer's former spouse used the property as a principal residence. Gain is allocated based on the time the property is utilized for qualified and non-qualified uses. This limits the ability to convert a vacation home, or rental or investment property into a principal residence for at least two years before its sale to avoid recognizing the gain.

Gain not subject to the new rule includes: i) gain for any period before January 1, 2009; ii) time after the last date the property is used as the principal residence during the five-year period ending on the sale date (you can move out prior to sale); iii) any period (maximum aggregate 10 years) taxpayer or taxpayer's spouse is serving on "qualified official extended duty" as an armed forces member, a Foreign Service officer, or an intelligence community employee; iv) for other temporary absence not exceeding two years in the aggregate because of a change of employment, or health conditions; or iv) for other temporary absences due to unforeseen circumstances specified by the IRS.

The ratio computation is determined after applying rules reducing gain excluded by depreciation allowed or allowable. Taxpayer's gain attributable to depreciation allowed or allowable after May 6, 1997 is not excluded from income, so not included when calculating the amount of gain allocated to non-qualified use.

Use of part of the property for business applies as under prior law. No allocation of gain f is required if the both the residential and business portions of the property are within the same dwelling unit. If the portion of the principal residence used for business purposes is separate from the dwelling unit, gain from the sale or exchange of the property must be allocated between the residential and business portions of the property. Any depreciation taken after May 6, 1997 must be recaptured out of the potential gain realized.