Capital Gain Exclusion for Second Homes

The recently enacted Housing and Economic Recovery Act of 2008 provides the housing market with important incentives, including the new first-time home buyer tax credit, it also contains some potential costs to home sellers.

Home sellers should note that the legislation also includes a change to the capital gain exclusion rules for second homes that is effective for sales after 2008. Since Park City, UT is a favorite second home area for many people, these new rules are important.

Under the old law, home owners could exclude from taxation up to $500,000 ($250,000 for single taxpayers) of capital gain from the sale of a principal residence in which the taxpayer must have lived for at least two of the five years before the home was sold.

The new law narrows the existing exclusion for second home owners. Home owners who own only one home remain unaffected at all by the new rules and may continue to exclude up to $500,000 or $250,000 in gain from the sale of their principal residence (although there are possible changes to this that we won't know much about until after the upcoming change in the Presidency).

Currently, taxpayers must continue to meet the existing test of living in the home for two of the five years preceding the sale, but the maximum amounts that can be excluded from taxation are reduced proportionately by the number of years in which they owned the home but did not occupy it as a primary residence.

For example, suppose a buyer purchases a second home on Jan. 1, 2009 and sells it 10 years later on Jan. 1, 2019, using it as a primary residence only during 2017 and 2018. The 2-of-5 year test has been met, but because the home was only used as a primary residence for 20% of the total ownership period (two of the 10 years), the $500,000 ($250,000) capital gains exclusion cap is reduced by 80% to $100,000 ($50,000).

There are grandfathering exceptions for existing owners of second homes. Under these exceptions, any time period of ownership prior to 2009 is treated as a period of primary residency for the purpose of calculating the nonqualified use.

For example, suppose a taxpayer purchased a second home on Jan. 1, 2005 and sells the residence on Jan. 1, 2015, using the home as a primary residence only during 2013 and 2014. Unlike the previous example, in which the taxpayer could only qualify for two years of using the home as a principal residence, under the new law's grandfathering rule six of the 10 years qualify for the tax exemption � 2005, 2006, 2007 and 2008, as well as 2013 and 2014. The taxpayer is able to exclude up to 60% (six of 10 years of qualified use) of the $500,000 ($250,000) gain exclusion amounts, or $300,000 ($150,000.)

There are other exceptions to how the new law defines nonqualified use; most notably, any period of ownership within the five-year window after the two-year test has been satisfied can be considered a period of qualified principal residence use. For example, if a home is used as a primary residence in 2010 and 2011, then years 2012 through 2014 are treated as years of primary residency even if the home was used for other purposes, including rental or vacation property.

Our government made these changes to the principal residence gain exclusion for two reasons.

One; for some time there was a desire to tighten the gain exclusion rules so that they applied only to owner-occupied principal residences and not to homes held primarily as rental property, which thereby received an unfair tax advantage over other owners of residential rental property, including multifamily developers.

And Two; congressional leadership insisted on making the Housing and Economic Recovery Act of 2008 revenue neutral.

The change to the principal residence gain exclusion rules was one of many revenue-raising provisions included for this purpose and needed to enact the landmark housing stimulus package. The provision raises approximately $1.4 billion over 10 years about 0.5% of the tax expenditure of the prior rules.

These new rules will take some time to show their full effect, but will in time be very important to sellers of second homes in Park City, Utah. The Group encourages you to speak with your tax advisor to determine how this may affect your future purchases or sales of secondary residences.

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