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Although the Housing and Economic Recovery Act of 2008 provides tax breaks for first-time homebuyers and non-itemizing homeowners, it may increase taxes for those who convert a vacation home or rental property to a primary residence before selling it. Below is an explanation of this new provision.

An individual homeowner can exclude up to $250,000 ($500,000 if married) on gain realized on the sale of a principal residence. To be eligible for exclusion, the home must have been used as a residence for at least two of the five years ending on the date of the sale. An individual or couple owning more than one home could double the value of the tax deductions by careful timing, i.e., living in one home for two years, selling it and excluding up to $500,000 of any gain, then moving into the second home and treating it as a new primary residence and selling it after two years and once again taking the exclusion.

The new housing law, in order to prevent such a double exemption, provides that a homeowner cannot exclude the gain from a sale that includes periods of “non-qualified use.” This includes any period, beginning in 2009, when the home is not used by the homeowner as a principal residence. Use of the home as a vacation home, or as a rental property, would be considered non-qualified use.

Examples:

#1: Assume a person buys a property on January 1, 2009 for $400,000, and uses it as rental property for two years while claiming $20,000 of depreciation deductions. On January 1, 2011, the person converts the property to a principal residence. On January 1, 2013, the person moves out and sells the property for $720,000. As under present law, the $20,000 gain attributable to the depreciation deductions is included in income. Of the remaining $320,000 gain, 40 percent (2 years divided by 5 years) – or $128,000 – is allocated to non-qualified use and is not eligible for the exclusion. Since the remaining gain of $192,000 is less than the maximum $250,000 exclusion, the $192,000 is excluded from income.

#2: Assume an individual buys a principal residence on January 1, 2009 for $400,000, moves out on January 1, 2019. On December 1, 2021, the property is sold for $600,000. The entire $200,000 gain is excluded from gross income, as under present law, because periods after the last qualified use do not constitute non-qualified use.

Please contact your tax professional before taking any action on this.