Brian Wynne, CPA

Memorial Day weekend may still be a month away, but as you daydream about your sunny-day beach house getaway, there may be some dark tax clouds looming over the horizon.  The Housing and Economic Recovery Act of 2008 (signed into law on July 30, 2008) contained a rather onerous provision related to the sale of vacation homes.  You may no longer be able to use the $250,000 ($500,000 if married filing jointly) home sale exclusion to reduce the gain from a sale, even if you lived in the house for 2 of the last 5 years.

Tax Consequences of Selling Your Home

Normally, you can exclude from taxable income up to $250,000 ($500,000 if married filing jointly) of gain from the sale of property if, during any 2 of the last 5 years, you used that property as your principal residence.  For most people, this means that if you’ve lived in your home (as your principal residence) since you bought it, you simply have to stay 2 years and then some (if not all) of the gain is excluded from tax.

Because of the way the test works (2 of the last 5 years), it was possible to avoid paying income tax on the gain of another property (like a rental property or more likely a vacation home) if you were willing to live there for just 2 years before you sell it.  For example, you and your spouse purchase a beach house in 2009 for $450,000, and use it for vacations for a few years.  In 2012, you want to think about selling the property now worth $650,000, and you basically have two options.  One: sell it now and pay capital gains tax on the appreciation ($200,000).  The other option is to move into the house (use the house as your principal residence) for 2 years, and then sell it.  So, if in 2014, the house is now worth $775,000, but now you’ve lived in it for 2 years, you can avoid tax altogether, as the total gain (from 2009 to 2014, $775,000 – $450,000 or $325,000) is less than the $500,000 exclusion for the sale of your principal residence.

Per the Internal Revenue Code, you can only use this exclusion once every 2 years, but it is not hard to see how you could have used this method to avoid a significant amount of income tax – especially if you bought the beach house during your working years as a vacation home, sold your principal residence when you retired (using the $500,000 exclusion there), then move to the beach house to enjoy a few years of retired life, and then sell that property as well, using another $500,000 exclusion.

Closing the Loophole

As I mentioned above, the law has now changed.  Thanks to the 2008 law, the $250,000/$500,000 exclusion is now only available for the periods when you actually use the home as a principal residence (qualified use), and the gain must be allocated between those times and any time when the home is not a principal residence (nonqualified use).  This allocation is done based on time only; there is no provision for periods of quicker or slower market appreciation (or even depreciation).  So, in our earlier example with the vacation home, the home was purchased in 2009 for $450,000 and sold in 2014 for $775,000 for a gain of $325,000.  But, using the new rules, 3/5 of the 5 years of ownership is nonqualified use, since it was not your principal residence, so $325,000 * 3/5 = $195,000 is gain that is subject to tax.  The other 2/5 ($130,000) can be excluded, since it is less than the $500,000 total available exclusion.

This change renders the old strategy ineffective.  Any nonqualified use after 2008 reduces the gain that you can exclude.  Even if you live there for 5 full years before sale, if you have nonqualified use before that 5 years (but after 2008) the gain will still be partially taxable.  It may not be enough to deter you from buying your dream house before you are ready to move in full-time, but it is something to think about as you plan your retirement years.

You should consult your tax advisor for any specific scenarios, or contact Bond Beebe for all of your tax and retirement planning needs.

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