Deep in the folds of the recently signed American Jobs Creation Act of 2004 – the same law that will allow residents of the seven states that don’t levy a state income tax to deduct sales taxes from their federal income tax in 2004 and 2005 – is a subtle yet important change for homeowners who have acquired their principal residence via a tax-deferred exchange.

The new law, signed by President Bush last month, includes a stipulation that the exchange property must be held for five years in order to qualify for the $500,000 ($250,000 for a single person) principal-residence tax-free exemption.

“It may be disguised as a safe harbor for people who buy an investment property, rent it out for three years, then live in it for two years before selling it,” said Kelly Yates, attorney and exchange specialist for Exchange Facilitator Corp. “Yet it appears that they are trying to clamp down on people who simply buy investment properties and then move in to them.”

In order to qualify for the $500,000 exclusion ($250,000 for single persons), homeowners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

The committee that drafted the section of the new law did not believe the principal-residence exclusion “was appropriate for properties that were recently acquired in like-kind exchanges.” Under the exchange rules, commonly known as 1031 exchanges or Starker exchanges, a taxpayer who exchanges property that was held for productive use or investment for “like-kind” property may acquire the replacement property on a tax-free basis. Because the replacement property generally has a low carry-over tax basis, the taxpayer will have taxable gain upon the sale of the replacement property.

However, when the homeowner converts the replacement property into a principal residence, the taxpayer may shelter some or all of this gain from income taxation. The committee believed that this proposal “balances the concerns associated with these provisions to reduce this tax-shelter concern without unduly limiting the exclusion on sales or exchanges of principal residences.”

While the new “Five-Year Rule” is important – especially to folks looking to move into a rental property they have owned – it is not critical. That’s because an investment property typically needs to be rented (used as an investment) after an exchange to show the exchange was clearly an investment-for-investment transaction. Accountants say the exchanged property should be held for at least two years as an investment property before an owner considers converting it to a primary residence. In addition, once the homeowners move in to the new primary residence, they must stay at least two years before qualifying for the $500,000 exclusion.

When you add the suggested two years as investment property with the two years required under the residency guideline, that’s four years minimum needed for the new mandatory Five-Year Rule.

For those who leave their home because of a disability, a special rule makes it easier to meet the two-year requirement – especially if you were hospitalized or had to spend a significant period in a similar facility. In such cases, if you owned and used the home as a principal residence for at least one of the five years preceding the sale, then you are treated as having used it as your principal residence while you are in a facility that is licensed to care for people in your condition. This rule, especially helpful for some seniors, enables the family to sell the home to raise cash for the expenses without incurring a large tax bite.

Yates and other tax attorneys caution that all exchanges must meet the “facts and circumstances” test regardless of how much time has passed before converting an investment property to a personal residence. If it’s clear at the time of the exchange that a taxpayer intended to use the exchange property as a primary residence, the exchange can be attacked, Yates said.

A tax-deferred exchange proceeds just as a “sale” for you, your real estate agent and parties associated with the deal. In fact, Richard Morse, attorney at Washington Exchange Services, refers to exchanges as “legally sanctioned fiction.” Section 1031 of the Internal Revenue Service code specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.

If you’ve traded for a golf course getaway condo and now think you would like to live there, make sure you own it for five years before attempting to pocket a principal-residence exemption.

However, once you get there, do you think you’ll ever want to sell?

Tom Kelly’s new book “How a Second Home Can Be Your Best Investment” (McGraw-Hill, $16.95) was co-written with John Tuccillo, former chief economist for the National Association of Realtors and is now available in local bookstores. He can be reached at news@tomkelly.com.

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