Mortgage Cancellation Relief: H.R. 3648

How H.R. 3648 Impacts Taxation on Some Vacation Homes

A harsh reality of tax law changes is that any benefit provided to taxpayers must be "paid for" with a revenue offset. In order to "pay for" the mortgage cancellation relief, the Ways and Means Committee modified, but did not eliminate, a tax planning opportunity for owners of vacation and rental properties. Under current law, the owner of a vacation home or rental property may sell his/her principal residence, exclude up to $500,000 of the gain from taxation, and then convert the second property into his/her principal residence. Once the 2-year residency requirement has been satisfied, the individual may sell that property and once again exclude as much as $500,000 from taxation.

The new rule modifies the application of the exclusion when an individual converts a rental or vacation property to his/her principal residence. Under the new rule, effective January 1, 2008, the owner will still have the option of receiving the benefit of the exclusion, but will be required to pay capital gains taxes on the appreciation attributable to the time that the property was used as an investment property. The amount excluded will be a fraction, determined at the time the vacation/rental property is sold. Assuming that the owner has satisfied the 2-year residence requirement, the amount of gain that can be excluded will be determined by a fraction. The numerator of the fraction will be the number of years the property was used as a principal residence. The denominator will be the number of years the individual actually owned the property, measured from January 1, 2008. Thus, the legislation has no retroactive impact. Congress sought a policy that would provide a capital gains exclusion on a principal residence only for the time that the property was actually used as a principal residence.