Most homeowners now know that under section 121 of the Internal Revenue Code up to $250,000 of gain can be excluded from the sale or exchange of their home as long as they own and occupy the home as a principal residence for at least two out of the most recent five years before sale. The exclusion is $500,000 for married couples filing a joint return. There are also a couple of rules that allow a partial exclusion if the taxpayer has to make an emergency move.

What many people don’t know is that Congress has begun to phase out many of the tax-planning opportunities that had been facilitated by sec 121.  The Housing and Economic Recovery Act passed on July 30, 2008 contains a provision to phase out the exclusion of gain on the sale of a principal residence to the extent that it has been used in any non-qualifying capacity.  A period of non-qualifying use means any period of time that the taxpayer did not use the residence as a principal residence. This could be a period of rental use, second-home use, investment use, or trade or business use. Under the new rules the excludable gain is reduced by the fraction of the time that the property was used in a non-qualifying capacity divided by the total ownership period.

Although this ends many tax-planning opportunities that formerly existed, taxpayers can still save money with some careful planning because non-qualifying use refers only to periods after January 1, 2009 and does not include the (three year maximum) period of time after the taxpayer stops using the property as a principal residence.

This is important for homeowners that own a vacation home, rental home, vacant lot or other non-qualifying use property that they bought with the intention of converting it to their principal residence at some point in the future. Under the old rules, after a period of time had elapsed, the IRS would consider the property to be converted to personal use making the whole of any subsequent gain on resale available for the $250,000/$500,000 exclusion. The new rules consider the gain attributable to the non-qualifying use (on a straight-line basis) non-excludable, therefore taxpayers in this situation should convert to personal use sooner rather than later. This will have the effect of minimizing the disqualified portion of the gain on the ultimate resale of the home (in perhaps ten or twenty years time) and minimizing the tax due.