Exchange Property Converted to Residence
Since 1997, Code Section 121 allowed a taxpayer to exclude $250,000 ($5000,000 if married) of capital gains tax when selling a primary residence after having occupied the dwelling for two full years of the preceding five years.
In 2004, IRS added the requirement that property acquired as investment or income property through an IRC Section 1031 exchange and subsequently converted to a primary residence for a minimum of 2 years could be sold by the taxpayer under Section 121 provided the taxpayer owned the property for a full five years.
The Housing Assistance Act of 2008, effective January 1, 2009, further limits the exclusion of gain from the sale of a residence which is allocated to any time of "nonqualified use." Nonqualified use is the time period in which the residence was not used as primary residence.
Example: Taxpayer acquires a property through a 1031 exchange in January 2009, and maintains the property as a rental. In January 2012, the taxpayer moves into the property and converts it to primary residence. In January 2015, the taxpayer sells the property. Three of the six years of ownership were nonqualified use for the primary residence exemption. The taxpayer would only be allowed to exclude 3/6 (or 1/3) of the gain from the sale under Section 121.
Importantly nonqualified use prior to January 1, 2009 is not taken into account in the allocation for the nonqualified use period, but is taken into account for the ownership period.
Example: Taxpayer acquires a property through a 1031 exchange in January, 2007 and maintains the property as a rental. In January, 2010 the taxpayer converts the property to a primary residence and continues to reside there until January, 2013. If the taxpayer sold the residence in 2013 only the 2009 rental period will be considered nonqualified use, thus only 1/6 of the gain would be ineligible for the exclusion.