Home sale gain exclusion
QWe Are considering moving into one of our rental houses. If we sell the property after living in it for two years, can we take advantage of the $500,000 capital gain exclusion for a principal residence? Can you please explain the rules?
ATo pay for the $15.1 billion of housing tax incentives in the Housing Assistance Tax Act of 2008 (the Housing Act), Congress passed several offsetting revenue raisers, including tightening the homesale exclusion rules.
Most homeowners are aware of the homesale exclusion, a provision of the tax laws which provides that homeowners who sell their principal residence typically do not need to pay taxes on as much as $500,000 of their gain if they meet certain conditions. The $500,000 exemption is the maximum exclusion for a married couple filing jointly: taxpayers filing individually get an exemption of up to $250,000. To be eligible for the full exclusion, a taxpayer must have owned the home and lived in it as his or her principal residence, for at least two of the five years prior to the sale. Because of the “principal residence” requirement, vacation or second homes normally do not 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.
The Housing Act closed 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 is 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 upto-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The law, in effect, reduces the exclusion based on a 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 the pre-Act law would be reduced by fourfifths to $80,000.
The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of this provision. Also, the law does not 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.
Barry Dolowich is a certified public accountant and owner of a fullservice accounting and tax practice with Monterey. He can be reached at 831372-7200. Please address any questions to Barry at PO Box 710 Monterey, CA 93942 or email: bdolowich@gmail.com.