WASHINGTON u Deep in the nearly 700 pages of the new housing bill just signed into law is a complicated tax code change that could affect substantial numbers of people who purchase second homes or rental investment real estate in the coming decade with an eye to occupying them as their main residence later.
The bill narrows the use of the codeEs tax-free exclusion that allows sellers of principal residences to escape taxation on the first $500,000 of their profits (married joint-filers) or $250,000 (single-filers). Under current law, sellers can claim the full exclusion if they have used a property as their principal residence for at least two of the five years preceding a sale.
They can also claim the exclusion even if they convert an investment property or vacation house into their principal residence and live there for at least two years. This flexibility has been a boon to many tax-wise owners of multiple houses u particularly during the bubble years when values doubled in some parts of the country.
Property owners in markets with high appreciation rates could sell their principal residences for hefty profits u pocketing the first $250,000 or $500,000 tax-free u and then move into their rental condo or vacation property for a couple of years and repeat the process.
In effect, it was a form of financial alchemy where taxable profits could be magically transmuted into tax-free gains u at least up to the $250,000 and $500,000 limits.
That practice eventually caught the eye of tax reformers on Capitol Hill. Last year the House approved a bill that would ratchet down the rules on such transactions by distinguishing between "nonqualified" periods of rental or investment use and "qualified" periods of principal residence use. It resurfaced this year in the housing bill as a "revenue offset" u a way to raise an extra $1.4 billion over the next decade.
HereEs how the new rule is expected to work: If you buy a second home or investment property on or after Jan. 1, convert it later into your principal residence and then sell, youEll need to allocate any gain from the sale between periods of qualified and nonqualified usage. Rental or second home usage before 2009 is grandfathered u it wonEt count as nonqualified use in the equation.
The minimum period for qualified principal residence use will remain as under current law u two years out of the five preceding the sale. Any nonqualified use will have to be toted up to limit the amount of the tax-free exclusion you are allowed.
Sellers in future years will need to create a fraction against which to multiply their total gain. …