A long known “loophole” strategy in real estate has been to purchase a vacation home or a rental property and one day convert it to your principal residence. Then, you could use the home sale exclusion rule to exclude up to $500,000 in gains (for married filing jointly). Well, if that was your strategy, it might be time to rethink it or analyze it a bit further. The latest tax bill passed on July 30 will make some changes to this law.
After 2008, some homesellers who don’t use their properties as principal residences for their entire ownership period may wind up paying more of a tax bill than they would under current rules (or pay tax when none would be owed currently). The tax break affected is the homesale exclusion, which generally allows up to $250,000 of homesale profit to be tax-free if a home was owned and used by the seller as a principal residence (i.e., main home) for at least 2 of the 5 years before the sale. In general, the tax-free break can only be used once every 2 years. The tax-free profit amount is up to $500,000 for married taxpayers filing jointly for the year of sale if several conditions are met. Because of the “principal residence” requirement, vacation or second homes normally don’t qualify for the exclusion. However, in what some saw as a loophole, the law permitted taxpayers to convert their second home to their principal residence, live in It for two years, sell it, and take the full $250,000/$500,000 exclusion available for principal residences, even though portions of their gains were attributable to periods when the property was used as a vacation or second home, not a principal residence.
For sales after 2008, the homesale exclusion will be reduced proportionately for the period of time a home wasn’t used as a principal residence. The prime example is a vacation home that is turned into a principal residence by its owners, but the new rule also can hit individuals who use a property as a main home for a while, rent it out for a period of time, and then move back in. There are, however, a number of exceptions. For starters, pre-2009 periods of non-principal-residence use don’t count, and neither do periods of temporary absence totaling no more than 2 years due to health or employment changes (or certain unforeseen circumstances), or up to 10 years of absence for qualifying members of the military or certain government employees. Finally, non-principal-residence use doesn’t count if it occurs (1) in the five years preceding the sale, but (2) after you permanently stop using the home as a main home.
The new law closes that “loophole” by requiring homeowners to pay taxes on gains made from the sale of a second home to reflect the portion of time the home was not used as a principal residence (e.g, vacation or rental property). The amount taxed will be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The new law in effect reduces the exclusion based on the ratio of years of use as a principal residence to the total time of ownership. For example, if a taxpayer owned a vacation home for ten years, but lived in it as a principal residence only for the final two years prior to sale, the maximum available exclusion would be reduced by four-fifths. Accordingly, a $400,000 gain on the sale that would be eligible for the full exclusion under pre-Act law would be reduced by four-fifths, to $80,000.
The good news for current owners of second homes is that the new law is not retroactive. The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of the provision. Also, the new law doesn’t change the rule that allows homeowners to take advantage of the homesale exclusion every two years. Taxpayers can still “home hop” with full tax exclusion if they only own one home at a time. Moreover, the taxpayer still qualifies for capital gain treatment on the amount of gain that cannot be excluded. As you can see, the new rule is quite complex and down the road will cause big headaches for some homesellers unless they’re careful and get an expert’s advice. Call us if you would like to sort out your situation and see what effect this law change will have for you.