Housing Assistance Tax Act of 2008 – Part 2

Well, here is the bad news I promised on the Housing Assistance Tax Act of 2008 and that is the closing of a “loophole” that was a great piece of tax planning for clients with rental properties.  I fail to see the “assistance” in this tax act…

Under current law, you can take a property that was rental property or vacation home, make it your primary residence for 2 out of 5 years, and then use the home sale exclusion to exclude taxable gain of up to $250k for single and $500k married-filing joint.  You would have to recapture any post May 6, 1997 depreciation you took on the rental property, and there are many other complexities you would need to go over with your CPA, but that should give you the general idea of what a great deal this is since normally the sale of a rental property would trigger capital gains tax – plus County and City tax if you are so unlucky to have rental properties with Portland or Multnomah County.

Well, unfortunately all sweet deals come to an end, and on 1/1/09 everything changes with regard to the home sale exclusion and properties that have had business use, or “non-qualifying use”.  For sales after 12/31/08, any business use of a property you later claim as a primary residence for purposes of the home sale exclusion is going to cost you.  Rather than deal with valuations on 1/1/09, the new law figures the portion of taxable appreciation on a pro-rata basis.  The total gain on the sale of the property will be multiplied times a fraction – (periods of non-qualified use after 1/1/09 / period the taxpayer owned the property).

For example, lets assume you bought a rental property in 2007 that you rented through the end of 2009 that then became your primary residence for 2010 and 2011.  You then sold the house conveniently on 12/31/2011 for a gain of $100k.  Also, while you rented the house lets assume you took $20k in depreciation.  How much of the gain is taxable under the new law?  Well, the house was rented for three years; however, the non-qualifying use is only for periods after 1/1/09, so we only calculate one year of non-qualifying use out of the five that you owned the property.  The taxable gain would 20% of $100k plus recapture of the $20k you took in depreciation, which is required under current law.  That last year of rental activity ended up costing you a taxable gain of $20k!

Of course I am simplifying the new law and there are likely to be some forthcoming guidance from the IRS on how this will all work and be reported, but it is definitely not good news.  My advice is that if you are looking to sell a rental property in the near future and don’t mind living in it for two years, I would suggest moving in before 1/1/09 to avoid the effects of this law.  As long as your exclusion covers the gain, then all you would have to worry about is the depreciation recapture, and hopefully in two years the housing market will have recovered so you could sell at a good price.  🙂

Well, hopefully that wasn’t too painful.  It is only money…


About Brian Germer, CPA

CPA with Parsons and Germer CPAs, LLP in Portland, OR

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