09/22/08: New Tax Law May Impact Vacation Homes

Housing Counsel

By Benny L. Kass

If you are planning to sell your vacation home within the next few years, you might want to move in and treat it as your principal residence as soon as possible. The recently enacted Housing and Economic Recovery Act of 2008 has closed a loop-hole in our tax law, and is estimated to raise almost $1 billion dollars over the next ten years.

Currently, if you move into your second home which you have been renting for many years, and live in it for two out of the five years before you sell it, you can exclude up to $250,000 of any gain that you make (or if you are married and file a joint tax return, the exclusion is up to $500,000.

But Congress – in an effort to offset other monetary losses which will be generated by the new law – decided to target second homes, which includes where you vacation every summer or your rental property.

Effective for property sales after January 1, 2009, you now have to allocate the percentage of time that you owned the property as compared to the time that it was not used as your principal residence.

Simply put, after January 1, 2009, when you sell your house that has not been used exclusively as your principal residence, you must “crunch the numbers” to determine any possible tax liability.

Let’s look at some examples:

1. On January 1, 2009, you bought a vacation home for $500,000. Two years later, you decided to move in and treat it as your principal residence. On January 2, 2014, you sell it for $800,000, giving you a profit of $300,000. Since you are single, under the old law you could exclude $250,000 of this gain. Thus, in this example, you will have to pay capital gains tax on the remaining $50,00, which at the current 15 percent rate, will set you back $7,500.

However, under the new law, you have to determine how many years after 2009 that the house was not used as your principal resident. In this example, the formula is:

Number of Non-Residential Years : 2 (2009-2010)

Number of Ownership Years: 5 (2009-2013)

Your non-excludable gain is $120,000 (2/5 X $300,000), and if the capital gains tax rate remains the same, now you will have to send the IRS $18,000.

But that’s not the end of the calculation. Remember that you can still exclude up to $250,000 of your gain for the period of use as a principal residence. Your excludable gain in this example is $180,000 ($300,000 – 120,000), and thus no additional tax is owed.

As you can see, under the new law, this transaction will cost you ad additional $10,500.

2. On January 1, 1995, you and your husband bought a property for $100,000, which was continuously rented. However, on January 1, 2013, you moved into the house and used it as your principal residence. On January 2, 2015, you sell it for $900,000. Over the years, you made $100,000 in improvements. Your total gain will be $700,000 ($900,000 – $200,000). Under the old law, since you have lived in the house for two out of the five years before sale, (and you file a joint tax return) you could exclude $500,000 of your gain, and only have to pay capital gains tax on the remaining $200,000. At current 15 percent tax rate, this would cost you $30,000.

However, under the new law, you have to determine how many years after 2009 that the house was not used as your principal resident. In this example, the formula is:

Number of Non-Residential Years : 5 (2009-2013)

Number of Ownership Years: 20 (1995-2015)

Your non-excludable gain is 5/20 X $700,000 or $175,000, and if the capital gains tax rate remains the same in 2015, you will have to send the IRS $26,250.

Once again, that’s not the end of the calculation. The remaining excludable gain in our example is $525,000 ($700,000 – 175,000). Accordingly, you will also have to pay tax on the remaining $25,000, which at 15 percent will cost you another $3,750.00.

You probably noticed that the tax due under the new law is the same as under the old law. Why? Because the longer you own your house, the less impact the new law will have. Additionally, the more profit you make, the new tax law’s impact will be reduced. Even under the old law, once your profit exceeds the statutory caps ($250,000 or $500,000), you have to pay capital gains tax.

In our examples, we did not include tax obligations to local and State governments, nor did we take into consideration such deductible expenses as real estate commissions. Additionally, if you depreciated your rental property, you may have to pay a recapture fee of 25 percent.

This is extremely complex and if you own other properties that may ultimately become your principal residence, you must consult your tax and legal advisors as soon as possible.