Let’s take them one at a time:

First, what happens if you sell a number of rental properties, exchange into one nice rental home at the beach, rent it out for a year, then convert it to your principal residence? Well, the answer is this: if you live there for two years after you convert it, then you qualify for an exclusion of tax on the first $250,000 or $500,000 of capital gain, depending on whether you are married.

The IRS saw that a number of landlords were using this technique to convert taxable capital gains on rental houses into excluded gains under Section 121, so in October of 2004, Congress revised Section 121, and I paraphrase:

If a taxpayer’s personal residence was acquired through a qualifying exchange transaction under Section 1031, then that taxpayer must own that residence for a minimum of five years before he can exclude gains from taxation under the personal residence rules of Section 121.

The effect of this ruling is simply to slow down the process.

Remember that exchanges under Section 1031 can only be made from an investment property into an investment property. So the acquired property must also be a rental of some sort. The big question is this: How long must I rent out the acquired property before I can move in and make it my principal residence?

Unfortunately, the IRS does not give us a specific answer. But most tax experts suggest a minimum rental period of one year to clearly establish your intent. Two years would probably look better, but might not be necessary.

In any case, under the new rule, you might rent the expensive beach house for a couple of years, then live in it for three years, then take advantage of the $250,000 or $500,000 exclusion. So long as you have owned it for at least five years, and resided there for any two of the five years preceding the date of sale, you will qualify.

And the second recent ruling from the IRS allows a home owner to benefit from both Section 1031 and Section 121, provided he qualifies for both. Let’s look at an example:

A couple bought a large house in Dunwoody for $100,000 in 1962, raised their family, then became the proverbial "empty-nesters" when their children moved on. Eventually, the husband passed away, but the wife stays in the home for several additional years. She eventually decides to sell for $650,000.

While the couple might have been able to exclude up to $500,000 from gain under Section 121, that is no longer possible due to the widow’s single status. If she sells today, she can exclude only $250,000, and will be taxed on the remaining $300,000 of gain. In Georgia, the tax bill might be as high as $63,000.

One solution is for her to remarry. As soon as both spouses meet the two-year use test, she could qualify for the full $500,000 exclusion. The excess gain of $50,000 will still be taxed as recognized capital gain.

But under the new Revenue Procedure 2005-14, there is another way to handle the problem.

In a nutshell, the IRS has said that if an owner lives in their residence long enough to meet the "two-year" requirement of the principal residence rules, then they have the right to convert their residence to investment use, and thus possibly also qualify for an exchange under Section 1031.

And here’s the kicker: if you qualify for both sets of rules at the same time, then you can first exclude from taxation the full amount for which you qualify, then use a "like-kind" exchange to defer the remaining gain into other property "held for investment."

As noted in our first example, the IRS does not tell us how long a property must be rented to prove that our intention is to hold the property for investment, but a rental of a year or more would likely be sufficient.

Thus our widow might move out, rent her house to others for a couple years, then sell it and exclude $250,000 under the personal residence rules. The remaining gain of $300,000 would then be eligible for deferral into any other qualifying property, so long as it will be held for investment.

If the widow wanted income, she might buy a fractional interest in a building under a triple net lease, and get a guaranteed check monthly for years to come. Or if she preferred, she might exchange into a condo at the beach, rent it out for a couple of years, then convert it to her personal residence.

Remember that she would still need to hire a Qualified Intermediary to handle the transaction, and that all the time requirements we discussed in recent weeks still would apply.

But both these rulings are welcome news to home owners all across America. Please be sure to talk with your CPA about your individual situation before you buy or sell any real property.