Changes to the Home Sales Capital Gains Exclusion Housing and Economic Recovery Act 2008

The Housing Act of 2008 contains a variety of provisions that could affect you: from property taxes, to jumbo loans to reverse mortgage limits. But the most important provision is a little-publicized revision of the tax code that impacts investors who own second homes or investment properties.

As with all tax modifications, the rules are complex. What follows is a broad overview of the new modifications to the home sales capital gains exclusion. Before making any decisions regarding real estate sales, you should talk to your financial advisor and CPA.

Modifications to the rules for home sales gains exclusion: last five years of use.

Old Rules:

Homeowner was allowed a capital gains exclusion of up to $500,000 (married couple) or $250,000 (single person) on a property that was used as a primary residence in at least two of the last five years.
Property used for investment purposes or as a vacation home during the balance of the five years didn’t affect the tax bill.

New Rules:

If your property is used for investment purposes or as a second home for any year prior to your living in it, your capital gains exclusion will be reduced. (The before provision)
If you first claim the property as your primary residence and then use it as an investment property or second home, there is no penalty. (The after provision)
The rule change begins January 1, 2009, meaning any non-qualified use of property (not a primary residence) prior to that date is not held against you.

Example: Couple owns a primary residence in Rhode Island and a rental property in Florida. They plan to sell the Rhode Island home on12/31/2011 – three years after the start of the Housing Act, move to Florida for two years to establish the rental property as their primary residence, then sell the Florida home and buy a new residence.

Old rules: our couple receives the maximum capital gains exclusion (for which they are eligible) for both the Rhode Island home and the Florida property.
New rules: our couple receives the maximum capital gains exclusion (for which they are eligible) for the Rhode Island home, but they lose a portion of the exclusion on the Florida home. They only get to count the home appreciation that is attributed to the time they occupied the Florida home. This means they will receive just 40% of the exclusion (two years), because the Florida property was used as a rental for three years (60% of the time) before they moved in.

Questions:

What if our couple moves to Florida this year (2008), rents their Rhode Island home and waits to sell it until the housing market turns around ostensibly in a couple of years?

No problem. Because the RI property became a rental after the couple used it as a primary residence, their capital gains exclusion will not be reduced.

Is there anything I should be doing now? After all, the rules don’t apply until 2009.

If you were planning to move into an investment property next year, you might seriously think of moving in before the end of 2008, especially if the investment property isn’t one that you want to be your permanent home. In this manner, you won’t have any penalties for non-qualified use of the property.

Plan ahead regarding the buying and selling of investment property, especially when using 1031 exchanges (a technique where one property is swapped for another property and taxes are deferred). Lots of people have enjoyed avoiding capital gains taxation on investment property altogether by simply living in the property two years right before they sell it. That loophole is now closed.

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If you are interested in discussing how the Housing and Economic Recovery Act 2008 could impact your personal situation, please feel free to call us with your questions.