New Rules for Capital Gains Taxation of Second Homes

vacation_home_taxThe IRS has targeted vacation homes, second homes, and even rental homes with new rules that govern taxation of capital gains. These new rules go into effect January 1, 2009.  Because ownership (or desire of ownership) of vacation homes is most common among baby boomers, it is an important issue to consider.

Our government and the IRS has given preferential tax treatment to vacation homes and other second homes by allowing the owners to keep all capital gains from sales of such homes, tax-free. There is a limit on the capital gains exemption of $500,000 for married joint filers.  If the taxpayer sold a principal residence and then lived in the vacation home as a principal residence for two years out of five, the second home could then be sold and receive the same exclusion from gross income on any gains from that sale.

The Housing and Economic Recovery Act of 2008 is causing the vacation home tax benefit to fade away. Effective January 1, 2009, the IRS will use a ratio of years occupied as a principal residence years to years used as a vacation home to calculate how much of the capital gain from the sale will be excluded from gross income.   The IRS will fortunately not include any years used as a vacation home prior to 2009 in the calculation.

In our case, if we were to change our present vacation home (which we bought in 2003) to be our principal residence at the end of 2008, then sell two years later, all of our capital gains (up to the $500,000 limit) will be excluded from gross income.   On the other hand, if we continue to use it as a vacation home for two more years (2009 and 2010), those “vacation home years” will reduce the percentage of capital gain that we can exclude from taxation when we sell our second home.  If we occupy our present vacation home for two years (2011 and 2012) then sell it, instead of having 100% of the capital gain being tax free, only 50% will be tax free.  (Two years used as a vacation home as a percentage of four years of ownership total after January 1, 2009.)

For any baby boomers who own a second home and use it as a rental property, the new IRS rules apply to you as well.

Technically, this change in the law was not a rule change but an amendment to the Internal Revenue Code.  Therefore, if you want to study the actual language of the new law, Section 121 (as amended) or the text of Public Law 110-289 is what you need to read.

The only silver lining I see in this change in the tax law is that it will probably make vacation homes and second homes less attractive to investors.  This decreased demand may, in turn, cause vacation homes to drop in value and become more affordable for those baby boomers (like Mr. GoTo) who see them more as a source of pleasure and relaxation and less as an investment.

Is this tax change affecting any decisions you are making?

Photo credit:  Matt Aiello


Comments

  1. says

    This is indeed a topic near and dear to my heart. We have a vacation home that we are converting to a principal residence–we moved there in March of 2008. My plan is to sell it some day (later than March of 2010) after we have lived there for 2 years. (Probably more like 3 to 5 to wait for the market to stabilize.)

    Then we will move back to our old principal residence, the house we expect to die in (therefore don’t really need the exclusion there.) In any case, we will live there so long that the ratio will have such a large denominator that we don’t lose that much if we eventually sell it.

  2. Mr. GoTo says

    Retired Std: I like your plan and hope that it works out the way you have prepared it. I also hope that the IRS doesn’t change the rules again. Keep us posted on how things proceed.

  3. Amy says

    We lived in the house for 11 years and we are moving to a new house and planning to rent the old house. If I rent for 4 years and then sell it. How much capital gain exemption can I get? How long can I rent to get some exemption ?

  4. says

    This is Another downfall of Obama. Penalizing American citizens, (true American citizens),that have worked and tried to have something in their life time.

  5. dan says

    I sold some property, only had to pay cap gains tax (rather than ordinary tax rates), and was still left with a substantial profit.
    Why does everything have to be politicized Betty? Although the law changed before President Obama was even inaugurated, I’m still not blaming President Bush; he helped close a big tax hole.
    You just need to understand the rules and plan accordingly.

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