The Section 121 tax incentives modification under HERA affects the $250,000 / $500,000 exclusion of gain on the sale of a principal residence. It is the only real modification to the existing traditional Section 121 and Section 163 real estate tax codes.
Beginning 1/1/2009, a second home (or rental property) that is converted to a principal residence will have to play by some new rules.
When the second home is sold, any gain attributable to use as a second home (or rental property) will be taxed at capital gains rates at that time. Any gain attributable to use as a principal residence will remain excludable, up to the $250,000 and $500,000 limits. Essentially you must now prorate the usage, whereas before you could potentially live there for 2 years and get the full exclusion… now you’d have to look back over the 5 year period and prorate the time spent as second home or investment and treat that based on capital gains, and the balance would apply toward the $250,000/$500,000 Exclusion.
If you own a second home (or rental property), PLEASE work with your tax advisor before selling and calculate your capital gains.