For many real estate investors, it was the most profitable tax strategy around: Move into a rental property you own, use it as a principal residence for two years, and convert taxable capital gains into tax-free dollars when you sell or exchange.

But Congress has just clamped a limit on investors' ability to play that game in the future. Under the 2008 housing legislation just signed into law by the President, you'll need to allocate between your investment-use time periods during your ownership of a house, and reduce your tax-free gains accordingly.

Here's a quick summary of the new rules imposed by Congress: There's no change to the basic benefits for taxpayers who use their homes exclusively as their main residence. As long as you live in a house for at least two of the five years preceding a sale, you can qualify for a tax-free exclusion of up to $500,000 in sale profits if you're married or up to $250,000 if you file returns singly.

The big change is for people who move into a house that formerly was rental or investment real estate. Under the old rules, you could move into a rental house or vacation condo, make it your main residence for two years, and convert all the gains built up in previous years into tax-free profits, up to the $250,000 or $500,000 limits.

Starting with properties acquired after next January 1st, however, you'll need to limit your tax-free treatment to the period when you lived in the property -- leaving the gains racked up during rental periods subject to taxes.

Consider this hypothetical example: Say you're single and you purchase a house for $400,000 next January 1 and rent it out. Two years later you move into it and use it as your main residence for the next two years. Then, on January 1, 2013, you move out and begin readying the property for sale. You close on January 1, 2014 for a price of $700,000.

Putting aside your depreciation writeoffs during the rental period, which are treated as taxable income, you've got a $300,000 gain. Under the old rules, you'd get $250,000 tax-free because you met the two years out of five test.

But under the new rules, you only get $180,000 because two years of your total ownership time is allocated to rental use, leaving two-fifths -- $120,000 -- of your gain subject to taxation.

We'll do a follow up on this important -- and tricky -- new tax wrinkle for investors next week.

Published: August 8, 2008

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.