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March 2006 |
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TAX LAW CHANGE - 2006 |
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The American Jobs Creation Act (signed by the President last fall) contained a tax change pertaining to real estate. Like many tax changes, it doesn’t affect all taxpayers. But, also like many tax changes, it is very important for those who are affected by it. The change, effective this year, is relevant to those persons who may have changed the use of what was once an investment property into that of their own personal residence.
If that former investment property had originally been acquired through an Internal Revenue Code Section 1031 tax-deferred exchange, then the sale of the property cannot qualify for the capital gains tax exclusion usually associated with sales of a personal residence unless the property has been held for a full five years. Of course the two-year’s use as personal residence rule will apply also.
Less this sound a bit esoteric, let us consider a bread and butter example.
Suppose that you and your spouse have been fortunate enough to own some investment real estate – perhaps a rental property – in addition to owning your own home. Over the years you might even have “traded up” the investment property, using the tax deferred method mentioned above. (This method is, in reality, simply a sale of one investment property and the purchase of another, more expensive one. But, if structured correctly, it qualifies as a “trade”, and capital gains taxes are deferred. It is quite common in the sale and purchase of investment properties.)
Sometimes people in such a situation will decide to do something like this: acquire an investment property that they will eventually use as their own personal residence. For example, you might live in Los Angeles and acquire an investment condominium at the beach. Your plan would be to rent out the condominium for a while, then sell the Los Angeles house (taking the $500,000 capital gains exclusion available to the two of you) and move to the beach – making the condominium your new personal residence.
Suppose you did this. Suppose you acquired the condominium through a tax-deferred exchange, rented it out for a year, and then moved into it after selling your Los Angeles residence. If, after two years, you then needed or desired to sell the condominium, could you – assuming it had appreciated – once again claim the $500,000 capital gains exclusion available on the sale of a personal residence?
Under the old rules you could, the crucial test being that you had occupied it as your own personal residence for at least two of the past five years.
Now, however, the rules have changed. Even though the two-year’s residence test has been met, if the property had been acquired through a §1031 tax-deferred exchange, then it must have been owned a full five years from the date of the exchange before the exclusion will apply.
I am not the one to ask as to the rationale behind this change. Apparently, our government did not like people being able to do what they used to be able to do. I suppose it has something to do with money, and the government having better access to yours.
In any event, although this is not a tax change that applies to everyone, it is an important one for those affected to know about.
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