Congress Curtails Benefit of Exchanges Involving Principal Residence

For many taxpayers, the best trick in the book is to exchange property they own into residential property that is eventually sold tax-free using the $250,000 exclusion ($500,000 for a couple filing jointly) available for sale of a principal residence. But with the passage of the American Jobs Creation Act of 2004, this widely used tax-avoidance technique is no longer available. Congress has essentially shut down this practice with a provision of the Act.

In structuring this kind of transaction, taxpayers would first exchange appreciated investment property they owned into either a residence or a lot on which a residence would be constructed. Second, they would then hold the lot for investment, or rent the residence as an investment for a period of time to establish an intent to hold the property for investment and thus qualify the transaction as a tax-free exchange. Third, they would experience an "epiphany" and decide to no longer hold the residence for investment, but rather to use it as their principal personal residence. Finally, after occupying the principal residence for the requisite two-year period under IRC ß121 to qualify for the $250,000 / $500,000 gain exclusion, the property could be sold tax free.

In Rev Rul 57-244, 1957-1 CB 247, the IRS held that residential property may be converted into qualified exchange property if the taxpayer has converted his or her use of the property as a personal residence. The reasoning of this Revenue Ruling would certainly apply to a conversion from investment property to residential-use property. Many taxpayers may have always...