New Tax Law On 2nd home & Investment Property

One of the most cherished part of the U.S. tax code is the provision that allows sellers to exclude up to $250K or $500K if they file a joint return of profit they make when they sell their homes. Not to worry. That's still around if you own just one property and have lived in it as your primary for at least two of the last five years before you sell it.

With the passing of the Housing Assistance Act of 2008, the bill designed primarily to provide relief to some homeowners facing foreclosure, will cost some folks who have a vacation homes, other type of second property including investment properties.

Effective this year, even if they convert their second piece of real estate or investment property into their primary home, they'll owe tax on part of the sales money based on how long the house was used as a second or investment, rather than their main, residence.

How it used to work?

The reason the law was changed? Money. The U.S. Treasury generally lost some every time a second home was sold by the owners who took advantage of the primary-home sale exclusion.

Under the old rules, if you owned your main home and place in the mountains that you used for family vacations, you could sell both and keep up to $250K or $500K, in profit out of IRS hands as long as you sold them in the correct order.

First, you would sell your primary residence and pocket that profit. Then you would move into the vacation place, live there for two years and then sell it. Because it had been your primary residence, you could exclude profit from that subsequent sale too.

There was no limit on the number of properties for which you could use the home sale exclusion. As long as you were able to make each place your primary residence and not claim the tax break for at least two years between each sale, you were in the tax clear.

How it now works

With the closure of the conversion loophole, now the seller of a second home or investment property, even if it's converted to primary residence status, will owe taxes for the time that the home was a second or investment property after Jan. 1, 2009.

You will take the number of years the property was your main home and divide that by the number of total years you owned it. That gives you the percentage of time that the house was your primary residence. You can exclude that much gain, up to the $250K or $500K limits, from your taxes.

The major determinant here is Jan. 1, 2009, effective date.

Example 1: Buy a second home or investment property in 2009

Let's look first at the tax ramifications if you buy a second home or investment property this year and use it for vacation getaway or a rental for 10 years. Then you sell your main home and move into this property full time, where you live for another 15 years before selling.

Your total ownership is 25 years, 10 as a vacation home, and 15 as your primary residence. Fifteen divided by twenty-five equals 60 percent, the amount of time it was your main home. So if you made $250K profit on this sale, under the new law you can only exclude $150K from tax. You have to pony up capital gains taxes on the remaining $100K profit.

But what if you've owned a second home for years? Let's find out.

Example 2: Second home or Investment property you already own

Using the same circumstances as before, we'll shift the ownership and sale calendar a bit.

This time, you owned your home for five years before the new law kicked in and five years after Jan. 1, 2009. You still have 10 years of vacation ownership and 15 years of living there as primary residence. But the new law doesn't count those five pre-2009 years of ownership as use that does not qualify for the exclusion.

So for tax purposes, your ownership calculation is five years as a second home or investment property and 20 years of use that are eligible for the exclusion. During those 25 years, the property was your primary residence or otherwise eligible for the exclusion for 80 percent of the time, meaning now you can exclude $200K of your $250K profit, with a balance of $50K in capital gain tax.

As of 2009

With the closure of the conversion loophole, now the seller of a second home or investment property, even if it's converted to a primary residence status, will owe taxes for the time that the home was a second or investment property after Jan. 1, 2009. Do note that for investment property sale; there is the additional recapture of depreciation tax which will apply at closing.

Please feel free to visit my company's website at www.AdelphiRetirement.com to learn about our company's services. You can also contact me at wlam@AdelphiRetirement.com. Thank you.