Beginning in 2009 investors who exchange for rental or second home properties and then later convert into their personal homes will no longer be eligible for the full $250,000 to $500,000 tax-free exclusions now available on sales of principal residences. New IRS rules will require them to allocate their time of ownership between taxable investment or second home usage and non-taxable principal residential usage.

It has been a fairly common practice for investors to shield themselves from capital gains by moving into exchange properties for a couple of years and thereby converting previously taxable gains into non-taxable principal residential profits.  Under the old law, an investor could exchange into a property, rented out for three years and move in and use the property as a principal residence for two years.  Establishing the property as a principal residence, triggered the tax-free exclusion of $250,000 to $500,000.  With the new law, the exclusion is pro-rated; applying only to the years it was a principle residence.

The new law could mean significant changes in the tax positions of some properties and requires a careful review.  Investors need to consult with their tax professionals and adjust strategies to avoid unwelcome tax surprises in the future.