As of January 1, 2009, a new housing law placed a restriction on the $250,000 exclusion allowed on gain from sale of a principal residence. If there is a period of “non-qualified” use after 2008, the portion of the gain allocated to that period won’t qualify for the exclusion. The provision primarily affects people who own vacation homes or rental properties but convert them to a principal residence for a period of at least two years prior to sale.
For example, you’ve owned a vacation home for many years and would like to sell it. You expect to have a gain of $350,000, and the entire gain would be taxable because you haven’t used the property as your principal residence. Rather than sell it now, you and your spouse make this home your principal residence for a period of two years, after which you sell it for a gain of $450,000. The home now qualifies as a principal residence.
Previous to 2009, this arrangement would have made it possible to exclude all the gain because you’re allowed an exclusion of up to $500,000 on a joint tax return. Under the current law, part of your gain would be taxable, but only to the extent you have non-qualified use of the property after 2008.
Generally you’re treated as having qualified use during any period you, your spouse or your former spouse use the property as a principal residence. All other time is treated as a period of non-qualified use, regardless of how the property is being used, or even if it is not being used at all.
To determine the amount of gain allocated to a period of non-qualified use divide the amount of time the property had non-qualified use by the total amount of time you owned the property.
For example, Zoe and Ruben bought a home in 2009 and own it as a vacation home for eight years. Now they are getting divorced and Zoe receives the rental as part of her property settlement.
Zoe decides to make it her principal residence for two years and then will sell it for a gain of $150,000. Of the ten years she owned the property, eight years were non-qualified use, so 80% of the gain doesn’t qualify for the exclusion. Therefore, she gets to exclude only $30,000 of the gain, even if most of the appreciation happened as a result of a sudden jump in value after she started using the home as a principal residence.
Although this tax law is nearly six years old, many people operate under the assumption of the pre-2009 tax law. During divorce, parties need to be aware of the current tax law prior to agreeing to their financial settlement.