The 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.
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