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Law Narrows Home Sellers' Use Of Tax-Free Exclusion

Deep in the nearly 700 pages of the new housing bill just signed into law is a complicated tax code change that could affect substantial numbers of people who purchase second homes or rental investment real estate in the coming decade with an eye to occupying them as their main residence later.

The law narrows the use of the code’s tax-free exclusion that allows sellers of principal residences to escape taxation on the first $500,000 of their profit (married joint-filers) or $250,000 (single-filers). Under current law, sellers can claim the full exclusion if they have used a property as their principal residence for at least two of the five years preceding a sale.

They can also claim the exclusion even if they convert an investment property or vacation house into their principal residence and live there for at least two years. This flexibility has been a boon to many tax-wise owners of multiple houses — particularly during the bubble years when values doubled in some parts of the country.

Property owners in markets with high appreciation rates could sell their principal residences for a hefty profit — pocketing the first $250,000 or $500,000 tax-free — and then move into their rental condo or vacation property for a couple of years and repeat the process.

It was a form of financial alchemy where taxable profits could be transmuted into tax-free gains — at least up to the $250,000 and $500,000 limits.

That practice caught the eye of tax reformers on Capitol Hill. Last year the House approved a bill that would ratchet down the rules on such transactions by distinguishing between “nonqualified” periods of rental or investment use and “qualified” periods of principal residence use. It resurfaced this year in the housing bill as a “revenue offset” — a way to raise an extra $1.4 billion over the next decade.

Here’s how the new rule is expected to work: If you buy a second home or investment property on or after Jan. 1, convert it later into your principal residence and then sell, you’ll need to allocate any gain from the sale between periods of qualified and nonqualified usage. Rental or second-home usage before 2009 is grandfathered — it won’t count as nonqualified use in the equation.

The minimum period for qualified principal residence use will remain two years out of the five preceding the sale. Any nonqualified use will have to be toted up to limit the amount of the tax-free exclusion you are allowed.

Sellers in future years will need to create a fraction against which to multiply their total gain. The numerator (top number) will be the time period the house was used as something other than a principal residence. The denominator (lower number) will be the total period of ownership.

The congressional Joint Tax Committee prepared an example to illustrate how the computation would function.

Say you are a single taxpayer and you buy a house next Jan. 1 for $400,000. You rent it out for two years and write off $20,000 in depreciation deductions. Then on Jan. 1, 2011, you convert the rental house into your principal residence. You live there for two years. On Jan. 1, 2013, you move out and put the place up for sale. On Jan. 1, 2014, you complete the sale of the house for $700,000.

As under current law, the $20,000 of depreciation write-offs is treated as gross income. The two years of use as a principal residence qualifies you for some amount of tax-free exclusion on the $300,000 gain. But how much?

To figure it out, you divide your aggregate period of nonqualified use (the two rental years) by your total period of ownership (five years) and multiply that fraction (two-fifths or 40%) against your gain of $300,000. The resulting number is the amount that’s subject to capital gains taxation — $120,000 in this case. The remaining $180,000 is tax-free.

Bottom line: If you plan to buy, reside in or sell a second home or rental investment property after Jan. 1, be aware of the new allocation formula. And talk to a tax advisor before making any big moves.