A popular way of turning investment property into tax free cash is to sell an investment property, such as a four-plex, and then roll the gain into a single family residence via a 1031 exchange. To qualify for the exchange you have to hold the residence as investment property for at least a year and a day, and our clients typically do this by renting it, or trying to rent it during this time.

Once this investment period is up, they then move into the residence and convert it to their home. Under current law, if you live in a home as your primary residence for at least two years, the exclusions available to you under Section 121 (the IRS Code Section governing the sale of your personal residence -- and giving you a $250,000 exclusion if you are single and $500,000 if you are married) are available to you even though all, or most, of the gain is rollover gain from your 1031 exchange.

In a bill signed by President Bush, the time requirements for owing the house in order to get the exclusions under Section 121 are extended to five years. For example, Fred and Sue sell their purple duplex and defer their $400,000 gain by buying a single family rental house. They have to rent, or try to rent this house, for a year and a day before they can move into it. Under the old law, they could move into the house and live in it for two years, and then sell it and the first $500,000 of gain would be excluded, even if $400,000 of the gain was rollover gain from their 1031 exchange. Under the new law they will have to own the house for at least five years, and live in it for at least two years in order to exclude the gain.

Before you moan and groan about this change, consider for a moment that under the old law you had to own the property for three years in order to exclude the gain -- the new law merely tacks two years to the holding period, which isn't such a big deal considering that the government is giving you $500,000 (or even $250,000) tax free.