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The rules concerning the exclusion of gain on a principal residence dramatically changed for years after 2008.

The general rules concerning sales of a principal residence through December 31, 2008 are the following:

Assuming that you meet the residency requirements, gains up to $250,00 of a residence are tax-free. For married taxpayers filing a joint return, the exclusion generally goes up to $500,000. The exclusion applies each time a principal residence is sold, as long as the residence was owned and used as the principle residence during at least 2 of the previous 5 years. However, under certain circumstances (e.g. military service or a job change) the two year requirement is partially waived.  

Residence acquired through "like-kind" exchange - if the residence was acquired through a tax free exchange of another property, the residence has to be owned and used as a principal residence for at least 5 years prior to the sale.  

The exclusion rules described above do not apply to any portion of the residence that is subject to depreciation after May 6, 1997. For example, if you can claim a home office deduction for one room of your residence, the gain (to the extent of depreciation taken since May 6, 1997) will not be excluded from your income.  You cannot avoid the depreciation exception to the exclusion rules by choosing not to depreciate the property on your tax return. The deciding factor is whether or not you were entitled to take the depreciation. Most likely the effect of this change will be relatively small, because the depreciation deduction is usually not very significant.  In addition, the current tax savings, due to the business use of the residence, are usually worth more than the future tax (if any) on a future sale.   

Other than the exception for depreciation discussed above, gain on the entire residence will probably qualify for the $250,000/500,000 exclusion as long as the property was used as the principal residence for at least 2 out of the last 5 years.  The general exclusion rules (other than depreciation since May 6, 1997) will probably apply, even though part of the property was used for business purposes.   Again, this rule is for sales occuring before year 2009.

The general rules concerning sales of a principal residence starting in year 2009 are the following:

The above rules are the same if the property is not converted to a non-residential use after December 31, 2008.  However, if the prinicipal residence is converted to another use (e.g. to rental property after 2008, the allowable exclusion is reduced by a numerator equal to time (after 12/31/08 the property was used for non residential purposes divided by the total time period the property was owned. For purposes of this fraction, the denominator includes any applicable time period before year 2009.  

In many situations, the new rules will have little if any affect the amount of available exclusion since the starting point of the reduction is either $250,000 or $500,000, depending upon the filing status.  For example, the total gain is much less than the maximum exclusin.  As long as the reduced exclusion is higher than the actual gain, the new rule has no affect.

Finally,  generally the numerator does not include any vacant peiiod between the time owner moves out of the principal residence and the date the property is sold.  However, in the situation where the seller moves out of his or her principal residence and the sale occurs more than 3 year later, none of the $250.000/500.000 applies; the owners do not meet the 2 out of 5 year requrement of use as their principal residence.  In certain cases, a long vacancy of the principal residence will not affect the exclusion.  Certain situations involving military service  allow for an extended period of vacancy.

There are a number of unanswered questions on how the new rules will affect situations where the principal residence is used partially for business.  Hopefully, the IRS will issue guidelines soon.

If you have any questions, you need to talk to your tax advisor.  If you are one of our clients, either you can call us or send us a secured Email by pressing here.

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