Second-home tax rules to change

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Owners of multiple homes need to mark Jan. 1, 2009, on their calendars. That’s the day that the rules change when it comes to how much profit you might be able to keep out of IRS hands when you sell.

One of the most cherished parts of the U.S. tax code is the provision that allows sellers to exclude up to $250,000, or $500,000 if they file a joint return, of profit they make when they sell their homes. Not to worry. That’s still around if you own just one property and have lived in it as your primary for at least two of the five years before you sell it.

But a provision of the recently enacted Housing Assistance Act of 2008, the bill designed primarily to provide relief to some homeowners facing foreclosure, is going to cost some folks who have a vacation or other type of second property.

Under the new law, even if they convert their second piece of real estate to their primary home, they’ll owe tax on part of the sale money based on how long the house was used as a second, rather than their main, residence.

How it used to work

The reason the law was changed? Money. The U.S. Treasury generally lost some every time a second home was sold by owners who took advantage of the primary-home sale exclusion.

Under the old rules, if you owned your main home and a place in the mountains (or beach or wherever) that you used for family vacations, you could sell both and keep up to $250,000 (or $500,000) in profit out of the IRS hands as long as you sold them in the correct order.

First, you would sell your primary residence and pocket that profit. Then you would move into the vacation place, live there for two years and then sell it. Because it had been your primary residence, you could exclude profit from that subsequent sale, too.

There was no limit on the number of properties for which you use the home sale exclusion. As long as you were able to make each place your primary residence and not claim the tax break for at least two years between each sale, you were in the tax clear.

How it will work

With the closure of the conversion loophole, now the seller of a second home, even if it’s converted to primary residence status, will owe taxes for the time that the home was a second property after Jan. 1, 2009.

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. “This time, it really is a prospective effective date,” says Bob D. Scharin, senior tax analyst from the Tax & Accounting business of Thomson Reuters.

That means someone who buys a vacation home next year, 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 and convert and sell it soon after the new law kicks it, your tax bite won’t be as much.

Buy a second home next year
Let’s look first at the tax ramifications if you buy another home next 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 already own a second home? That changes things in your tax favor. “Any time that you own the home before 2009 is not counted,” says Scharin.

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.

So for tax purposes, your ownership calculation is five years as a vacation home and 15 years as your main home. During those 20 years, the property was your primary residence for 75 percent of the time, meaning now you can exclude $187,500 of your $200,000 profit, a tax saving 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 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 rally benefited from this application of the law in a way that legislators apparently found unjust was 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 effect

Folks who do buy second homes, which the National Association of Realtors says account for around 40 percent of all homes 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.

“It may also have the effect of depressing the market for vacation property, something that legislators may not have intended,” Luscombe says.

One congressman is bothered by that possibility. “The damage caused by raising taxes on second-home owners won’t appear immediately,” says Rep. Kevin Brady, R-Texas, whose East Texas district includes several recreational lakes dotted with second homes.

“I am concerned that in the long run, this tax increase could hurt the resale value of second homes,” says Brady, “making them less attractive as an investment and possibly damaging the local economies of retirement and vacation communities.”

Timing is everything

The tax considerations of vacation-home owners, in Texas and across the rest of the United States, are part of the second reason why the change in the home sale law might not raise as much money as lawmakers had hoped.

People tend to alter their behavior to fit their needs, especially when taxes are involved. “They’ll just hold onto the houses until death and the basis will be stepped up for their heirs, who can sell for no capital gains,” Olivieri says.

If you prefer selling rather than leaving your vacation home to the kids, you still might be able to work out a tax-free sale situation.

The sale profit allocation formula only applies if you convert a second home to a primary residence on or after Jan. 1, 2009. “If you convert before the effective date,” Scharin says, “there’s no effect.”

You even could push it to the new law’s actual date. “If you can move into the vacation home on Jan 1, 2009,” says Olivieri, “you can sell the house and claim the full gain exclusion as long as you meet the requirement that you live in the home for two out of the last five years before the sale.”

Be careful, however, if your second property was rental real estate. You will still be required to recapture depreciation you claimed on the property, says Scharin.

On the plus side, though, the new law grants an exception for “nonqualified use,” or any time when the home wasn’t your principal residence, if the house’s original use was as your main home. A period of absence generally counts as qualifying use if it occurs after the home was used as the principal residence.

This exception could come in handy, for example, if you moved but were unable to sell your home because of a slow real estate market. Although technically the property is no longer your main home, since it started out that way, you don’t have to factor out that non-residential time, or nonqualifying period in tax-speak, when you do eventually sell and realize a gain, says Scharin. Of course, you do have to meet the other home sale exclusion rules, such living in the home as your main residence for two of the five years before the sale.

A new loophole

The special tax status granted to homes that started out as principal residences, regardless of how the property is used subsequently, also creates a new tax loophole.

There’s a way, says Olivieri, that current owners of both a primary residence and a vacation home can sell the properties and claim the full tax exclusion amount for both. He offers this example:

You have two homes, one clearly a primary residence and the other clearly a vacation home. On Jan 1, 2009, you move out of your principal residence and into your vacation home. You don’t have to sell your original principal residence yet, just move out of it.

Live in what once was your vacation house, but now your main home, from Jan. 1, 2009, until Jan. 2, 1011, to meet the two-year residency rule, then sell it and claim the full gain exclusion. Remember, if you have a gain in excess of the $250,000 or $500,000 exclusion amount, you still owe tax. But there’s nothing to prorate because you converted it on the new law’s effective date.

When you move back to the original primary residence, you can sell it and claim the full exclusion as long as you meet the tax rule that didn’t change: You live in it as your main home for two of the past five years before the sale. You can’t move in after 20 years, sell the next day, and get the full exclusion.

“You don’t have to prorate the exclusion to any period that it was not your primary residence if that period occurred after a period when it was your residence,” says Olivieri. “It is a new loophole, but one that was intentionally done.”