Effects of the Housing & Economic Recovery Act of 2008

The Effects of the Housing & Economic Recovery Act of 2008

By Matthew K. Scheriff, CPA, CES

The Housing and Economic Recovery Act of 2008 (“H.R. 3221”), signed by President George W. Bush on July 30, 2008 was designed primarily to restore confidence in Fannie Mae and Freddie Mac as well as help homeowners facing foreclosure in the current subprime mortgage crisis. Unbeknownst to most homeowners, the bill also includes modifications of Internal Revenue Code Section 121 (“§121”).

HR 3221 modifies §121 to exclude the gain from the sale of the primary residence that is allocable to periods of “non-qualified use”, which includes periods of use as a second home as well as a rental. Only the actual time that the real property was held and used as a primary residence will qualify for the tax free exclusion. Homeowners can no longer take the full tax free exclusion under §121 when the property was held and used for non-qualified use prior to it being held and used as a primary residence.

This will significantly affect those homeowners who had planned to move into investment property and convert its usage to their primary residence in order to benefit from the §121 exclusion. The longer the real property was held for investment, the more capital gain that must be included in taxable income.

The modification made by H.R. 3221 means that the ratio will not always be governed by the five year period during which a taxpayer must use the property as a primary residence, but rather by the total period of ownership of the property versus its period of non-qualified use. The gain is allocated based on the ratio which “(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.”

The capital gain allocated to the non-qualified use period will no longer be excluded from the homeowner’s taxable income. The capital gain allocated to the qualified use period (time used as a primary residence) will continue to qualify for the §121 exclusion and will be excluded from the homeowner’s taxable income.


  1. A homeowner owned real property for five (5) years originally purchased for $500,000 in January 2009. It was held as rental property for the first three (3) years and then converted to their primary residence for the last two (2) years and subsequently sold for $750,000.The non-qualified use period is three (3) years and the qualified use period is two (2) years. In this example, two-fifths, or $100,000, of the total actual capital gain can be excluded from taxable income as qualified use under §121 and three-fifths, or $150,000, of the actual total capital gain must be included in the homeowner’s taxable income as non-qualified use under §121.Remember that any depreciation recapture can not be excluded from taxable income under §121 and would be recognized and included in the year the property is actually sold.

The allocation rules only apply to time periods prior to the conversion into a principal residence and not to time periods after the conversion out of personal residence use. Thus, if a taxpayer converts a primary residence to a rental and never moves back in, and otherwise meets the two out of five year test under §121, the taxpayer is eligible for the full $250,000 exclusion when the rental is sold. For example, if a taxpayer lives in a property for three years and thereafter rents it for one year before selling it they would still receive 100% of the benefit under §121. The recent amendment appears to specifically target the §1031 exchangers that were utilizing strategies to convert tax deferrals (§1031) to exclusions (§121).

Qualified & Non-Qualified Use

Qualified use is defined as any use of the property as a primary residence. Non-qualified use is defined as any use of the property other than as a primary residence, including use as a second home, a vacation property, a rental or investment property or use in a trade or business. A period of nonqualified use does not include “any other period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or such unforeseen circumstances as may be specified by the Secretary”; as well as any period (not to exceed an aggregate period of 10 years) during which the taxpayer of taxpayer’s spouse is serving on ‘qualified official extended duty.’ A taxpayer claiming ‘qualified official extended duty’ must be a member of the armed forces, Foreign Service of the United States, or an intelligence officer working more the 50 miles from their primary residence or residing under government orders in government housing.

Effective Date

The modifications to §121 of the Internal Revenue Code apply to the sale of any real property closing after December 31, 2008 that was held and used as the homeowner’s primary residence. Furthermore, nonqualified use prior to January 1, 2009 is not applicable in the allocation for the nonqualified use period, but is taken into account when computing the total ownership period for purposes of the allocation. Thus, suppose the taxpayer had exchanged into the property in January 2007, rented the property for 3 years, then converted the property to one’s primary residence in January 2010. If the taxpayer sold the residence in 2013 after three years of primary residential use, only the 2009 rental period would be considered in the allocation for the nonqualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion.


The modifications of §121, cleverly included in the Housing and Economic Recovery Act of 2008, will have little to no impact on your average homeowner, but rather target real estate investors that have strategically maximized the tax benefits on investment property over the years. The new requirements are a means of tightening what was perceived to be an exploitation of a tax loophole whereby taxpayers were converting deferred gain into an exclusion of gain. The changes to §121, coupled with Revenue Procedure 2008-16, still potentially allow for preferable tax treatment on the sale of mixed use residential properties through §121 and/or §1031. However, taxpayers and their advisors will need to have a clear understanding of the recent changes as they evaluate the tax status eligibility and quantify the potential tax benefits available upon the sale of the properties.

Matthew K. Scheriff, CPA, Certified Exchange Specialist ®, is the Executive Vice President of Legal 1031 Exchange Services, a qualified intermediary for IRC §1031 tax deferred exchanges. He can be contacted at (877) 628-1031 or

Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.

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