You take the number of years the property was your main home and divide that by the number of total years you owned it. That gives you the percentage of time that the house was your primary residence. You can exclude that much gain, up to the $250,000 or $500,000 limits, from your taxes.
The major determinant here is the Jan. 1, 2009, effective date.
Anyone who buys a vacation this year or beyond and ultimately converts it to a primary residence and then sells it will feel the full force of the new law. But if you've owned your second place for many years before 2009 and convert and sell it soon after the law change kicks in, your tax bite won't be as big.
Example 1: Buy a second home in 2009
Let's look first at the tax ramifications if you buy another home this year and use it for vacation getaways for 10 years. Then you sell your main home and move into the holiday retreat full time, where you live for another 15 years before selling.
Your total ownership period is 25 years, 10 as a vacation home and 15 as your primary residence. Fifteen divided by 25 equals 60 percent, the amount of time it was your main home. So if you made $250,000 profit on its sale, under the new law you can only exclude $150,000 from tax. You have to pony up capital gains taxes on the remaining $100,000 of profit.
But what if you've owned a second home for years? That changes things in your tax favor. "Any time that you own the home before 2009 is not counted against you," says Bob D. Scharin, senior tax analyst from the Tax & Accounting business of Thomson Reuters.
Example 2: Second home you already own
Let's use the same circumstances as before, but shift the ownership and sale calendar a bit.
This time, you owned your home for five years before the new law kicked in and five years after Jan. 1, 2009. You still have 10 years of vacation homeownership and 15 years of living there as primary residence. But the new law doesn't count those five pre-2009 years of ownership as use that does not qualify for the exclusion.
So for tax purposes, your ownership calculation is five years as a vacation home and 20 years of use that are eligible for the exclusion. During those 25 years, the property was your primary residence or otherwise eligible for the exclusion for 80 percent of the time, meaning now you can exclude $200,000 of your $250,000 profit, a tax savings of $37,500.
The IRS will issue details on the exact tax calculation formula, as well as new forms and work sheets, to help home sellers figure their precise tax bills. Tax software companies will be close behind with their versions.
Just how much money?As the second home conversion and sale examples show, the IRS will collect some additional revenue from the law change. The Senate Finance Committee estimates that it will amount to around $1.4 billion over 10 years.
John Olivieri, however, thinks the new law will raise much less than that.
"Just look at the state of the housing market right now," says Olivieri, partner with the New York City law firm White & Case. "How many gains are there out there?"
Olivieri also believes that Congress might be counting too much on folks who own more than just two properties. "Before, if you owned four residences, you could sell the one you used as principal residence, claim the gain exclusion, move into residence number two, live there for two years, sell and claim the gain exclusion and just keep going through your properties this way," he says.
"The only people who really benefited from this application of the law in a way that legislators apparently found unjust were people who already owned all these residences and converted them to avoid tax on the gains," Olivieri says. "That's not a lot of people. Owning one vacation home is common. Owning a bunch is not."
Real estate investment side effectFolks who do buy second homes, which the National Association of Realtors says account for around 40 percent of all home sales, will need to think about more than how much fun they'll have at the new place. The future tax implications, says Mark Luscombe, principal tax analyst with tax publishing company CCH, may complicate planning for people looking at a second home.