Be careful when moving into your 1031 property

New modification may affect taxpayers who exchange into residential property then convert that property to a personal residence.

What this means: Your residential tax break will be affected if the sale property was converted from rental to primary residence.

On July 30, 2008, President Bush signed the Housing Assistance act of 2008 that includes a modification to the Section 121 exclusion. This provides an exclusion of gain on the sale of a primary residence.

Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 married filing jointly) of gain on the sale of a primary residence as long as they have lived in the property for 2 out of 5 years preceding the sale.

Under the new law, which is effective January 1, 2009, the Section 121 exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use”. Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence.

For example, a taxpayer exchanged into a property through a 1031 exchange and rented it for 4 years. The taxpayer then decides to move into the property, convert its use to primary residence for 2 years then sell the property and realize $250,000 of gain. Under the old law, this gain would be excluded under Section 121. Now, the 121 exclusion is prorated for the periods of time that the property was held for nonqualified use. This means that 4/6 or 4 out of 6 years of gain is ineligible for the $250,000 exclusion.

However, this change only applies to time periods prior to conversion into a personal residence. If a taxpayer converts a primary residence to rental and never converts the property back to primary use, then the $250,000 exclusion of gain is still valid.