*NEW RULES FOR TAXING GAIN WHEN A SECOND HOME IS
CONVERTED TO A PRINCIPAL RESIDENCE
CHANGES TO THE $500,000 EXCLUSION
Effective January 1, 2009
The 2008 Housing and Economic Recovery Act (HERA), H.R. 3221, included a $16 billion package of tax incentives intended to facilitate refinancing and also to encourage first-time purchasers to come into the market. These tax incentives required offsets so that the housing package would be revenue neutral. Only one offset was real estate-related. That change, described below, provided $1.4 billion of revenue to "pay for" the $16 billion of incentives. (The balance comes from the credit card industry and from some multinational corporations.)
This real estate-related provision affects only a limited set of circumstances. The new revenue raiser modifies the application of the $250,000/ $500,000 exclusion, but ONLY in situations in which an individual who owns a second home converts the second home to use it as his/her principal residence. When the former second home is sold, some portion of the gain may be taxable, even when the owner has lived in the home for the required two of the previous five years. Affected second homes are any residences the individual owns that are not used as a principal residence. Thus, both vacation and rental properties could be affected.
Another way to describe the goal of this change: a principal residence will be eligible for the full $250,000/$500,000 exclusion of gain on sale only when the property is used solely as the owner's principal residence.
The new rule is a so-called "use" test. It requires the owner of a second home that becomes a principal residence to compute the exclusion amount and any taxable gain based on the use of the property. Gains from investment/rental use will be taxed as investment gains at capital gains rates, just as gains from a second home or investment property would be taxed if the owner had never lived in the residence. Gains from principal residence use will be taxed under principal residence rules and, depending on the amount of gain, be eligible for part or all of the $250,000/$500,000 exclusion.1
Starting January 1, 2009, individuals who convert a second home to a principal residence and then later sell that property will use a fraction to determine the taxable portion of any gain and the amount eligible for the exclusion. The numerator of the fraction will be the amount of time, starting January 1, 2009, that the property is used as a rental or investment property/second home. The denominator of the fraction will be the total number of years of ownership, starting January 1, 2009. This is essentially a fresh start for all second home/investment property that becomes a principal residence. No appraisals will be required and people who have held these properties for a long time will not suffer any disadvantage.
1 In some circumstances in which the gain is very large and the proportion of use as a principal residence after 2008 is long, an individual may still be eligible to exclude amounts up to $250,000 or $500,000. In those cases, however, the non-principal residence use will still be taxable, as will gain over the exclusion amount.
The examples below illustrate the application of this new rule.
Example 1: Charlie, whose tax filing status is single, bought a vacation property on March 1, 2009. On March 1, 2012, she converts the property to her principal residence. On March 1, 2014, she sells the property for $700,000, realizing a gain of $300,000. Thus, she has owned the property for 5 years and used it as a principal residence for 2 years. On these facts, 40% of the gain (2 / 5) is eligible for the $250,000/$500,000 exclusion (2 years use as a principal residence divided by 5 years of ownership). The remainder of the gain (60%) will be taxed at the capital gains rate that applies in the year of sale.
Of the total $300,000 gain, $180,000 ($300,000 x .60) will be treated as a capital gain. If the capital gains rate in 2014 is still 15%, the total tax would be $27,000 ($180,000 x .15). Since the remaining $120,000 of gain is less than $250,000, $120,000 is eligible for the exclusion. Thus, the tax rate on the total $300,000 gain is 9% ($27,000 divided by $300,000).
Example 2: Same facts, except that Charlie acquired the property on January 1, 2003. To compute her period of ownership (the denominator of the formula), the 6 years before January 1, 2009 are disregarded. Thus, just as above, she will be taxed (at capital gains rates) on $180,000 when she sells in 2014 and will still be allowed to exclude $120,000 of gain from any tax (assuming no changes in the law).
[As of August 22, 2008, there was some uncertainty about the application of this formula to properties owned before 2009. Once the correct mechanics have been confirmed, this example will be updated.]
Example 3: Fred and Ethel have owned a townhouse that they've used solely as a rental property since 1989. They've decided to simplify by selling their big house in the suburbs and moving into the townhouse. They moved into it on April 15, 2008. In April 2019, they sell the townhouse so that they can move to a home all on one level. They have a low basis in the townhouse because it was used as a rental property for 19 years, leaving them with a gain of $600,000.
When they sell the townhouse, they will be eligible for the $500,000 exclusion because the property was their principal residence on January 1, 2009. In this case, they will pay tax on the $100,000 excess over $500,000 ($600,000 gain minus $500,000 exclusion) at the capital gains rate in effect for 2019. In addition, they will be liable for the depreciation recapture taxes for the years that the property was used as a rental property. The depreciation recapture tax will be imposed at the rate in effect for 2019. (That rate is presently 25%.)
Example 4: Same fact as #3, but Fred and Ethel both die in 2018, still owning and living in the townhouse. Their children inherit the property. All estate tax liabilities have been satisfied, but the heirs don't want to live in the townhouse or maintain it as a rental property. In 2019, they sell the townhouse for $900,000. The townhouse had a fair market value of $825,000 when Fred and Ethel died. (Assume that the estate tax rules still permit a stepped-up basis; i.e., the value of the property in the hands of the heirs is the same as the fair market value on the day of their parents' death.)
The property has been a rental property, a principal residence and part of an estate. When the heirs sell the property, they are permitted to treat the property as if it had been their own principal residence, so long as their parents had lived in the home for two of the five years before their death. Their gain on the sale is $75,000 ($900,000 - $825,000). The $75,000 gain may be excluded from taxation under the $500,000 exclusion rules.
If the estate tax rules are changed and require the heirs to use the same basis their parents had in the house, the result would be very different (and, as a practical matter, very difficult for the heirs to ascertain). If, for example, the parents' basis had been $125,000 and the heirs sell the property for $900,000, they would have a taxable gain of $775,000. $500,000 would be excluded. The remaining $275,000 would be subject to capital gains taxes at the rate in effect for 2019. It is not clear how any depreciation recapture amount would be taxed or how it would be determined.
Policy Considerations:
- No tax benefit is completely eliminated. New limits will apply in some cases.
- The policy goal of the change was to look to the use of the property after January 1, 2009. During periods the property is used as a second home (whether or not it is rented out) or as a rental investment, gain on sale will receive capital gains treatment. During the period it is used as a principal residence, gain on sale will receive principal residence exclusion benefits.
- The original policy objective of the $250,000/$500,000 exclusion was to provide tax benefit for property that is used as a principal residence.
- In all events, the full amount of a gain on the sale of the second home that is converted to a principal residence will be taxed at lower rates than gains on the sale of a second home that is not converted to principal residence use. This is because part of the gain associated with use as a principal residence will be non-taxable. (See Example #1.)
- The taxpayer still qualifies for capital gains treatment on the amount of gain that cannot be excluded. Owners of second homes that are never converted to principal residences will continue to pay capital gains taxes on the full amount of any gain.
- The provision eliminates retroactive application to any property owned before 2009.
*Posted by NAR summary as of August 22, 2008.
Comments (1)Subscribe to CommentsComment