The Housing Assistance Tax Act of 2008 has enacted a new limitation on the exclusion.
Code Sec. 121(b)(4) now provides that if a residence was at any time NOT used as a principal residence of the taxpayer, the portion of the gain allocated to periods of "nonqualified use" will not be available for exclusion.
Thus, if a taxpayer rented out a residence or used it only as a vacation home for a period, but still otherwise used the residence as a principal residence for the prequisite 2 years out of the preceding 5, the full exclusion may not be available.
The available portion of the gain available for exclusion is determined by multiplying the gain on sale by a fraction.
The numerator is the PERIOD THAT THE RESIDENCE WAS USED as a principal residence by the taxpayer, and the denominator is the ENTIRE PERIOD OF OWNERSHIP of the taxpayer.
The resulting amount of gain is eligible for exclusion (up to the maximum of $250,000/$500,000)