The Housing and Economic Recovery Act of 2008, passed in late-July, gets attention for reduction of foreclosures, giving a boost to the housing market, and shoring-up big lending institutions. Less attention has been paid to the fact that it will also change the amounts many taxpayers owe to the IRS. One aspect with particular application to the Flagstaff real estate market is the change to the principal residence capital-gains-tax exclusion as it affects vacation homeownership.
For the last many years, the principal residence capital gains tax exclusion has been summed up as “live in it for 2 of the previous 5 years” and you get a capital gains exclusion of $250,000 if you’re single and $500,000 if you’re married filing jointly. That’s still going to be true for your principal residence. Some affluent homeowners have moved from home to vacation home to the next home, repeatedly, avoiding income taxes on the sale of each one. That free ride is at an end. With it, may be another hit to an already-suffering second-home market in Flagstaff.
Starting January 1, 2009, vacation homeowners will pay capital-gains tax on the sale of vacation homes and on rental properties that are later converted to principal residences. The tax will be based on the amount of days the house was not a qualified personal residence divided by the total number of days you owned it. This ratio is multiplied by the amount of gain realized on the sale of the property. Here is an example from CCH:
“A couple buys a vacation home for $200,000 when they are in their 50s, sometime after this year. Ten years later, they retire, sell their old principal residence and make the vacation home their new principal residence. Fifteen years after that, in their 80s, they move to an assisted-living community and sell the home for $700,000, realizing a gain of $500,000. Under current law, the entire $500,000 gain would be excludable, but under the new provision, they could exclude only 15/25, or 60 percent of the gain from their income. So they would exclude $300,000 and include $200,000 on their return as a taxable long-term gain.”
"These possibilities may complicate planning for people looking at a second home," said Mark Luscombe, JD, CPA, CCH principal tax analyst. "It may also have the effect of depressing the market for vacation property -- something that legislators may not have intended."
Snowbirds, who typically summer in their principal residences up north and spend winter in their vacation homes in the south will have to wait until IRS writes regulations interpreting the new law. It's not clear if their temporary absences will be considered a period of nonqualified use. The new law defines unqualified use as:
- any period after the last date the property is used as the principal residence of the taxpayer or spouse (regardless of use during that period), and
- any period (not to exceed two years) that the taxpayer is temporarily absent by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances, are not taken into account.
If you make the property your principal residence first, then the 2 out of 5 seems to apply. But until the IRS regulations are released, tax preparers are going to be navigating uncharted territory with educated guesses.
One additional problem is for people who are building their custom dream homes. This issue was explained by Diane Kennedy in her Tax Loopholes blog. Typically, they live in their prior principal residence until the new house is completed. Often, construction can take six months to a year. Until the move-in, the new property is not their principal residence So, under this new law if your dream house turns out not to be your dream after all and you sell it two years later, you’ll only been able to exclude 2/3 of the gain. Ouch! But, in this market, there might not be a gain to worry about…. Wouldn’t that be worse?
Are you thinking of buying or selling a Flagstaff home? For expert residential real estate advice in the Flagstaff area, contact Team Heitland at RE/MAX Peak Properties. |
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