The housing stimulus package giveth and taketh; a tax-saving strategy used by the wealthy will soon be cut off to offset the costs of other tax breaks included in the stimulus package.
"Not last night but the night before, twenty-four tax collectors came a-knocking at my door." That's the new rhyme that homeowners may be singing if they want to play the game of "vacation home hopscotch," now that legislators have cut off a major tax loophole associated with capital gains on real estate.
The way things were
If you sell your home at a profit, U.S. tax law allows you to exclude up to $500,000 (married, filing jointly) of the gain from your taxable income. To qualify, you must have used the home as a primary residence for two of the five years preceding the sale, and you must not have taken the exclusion in the prior year.
For most homeowners, the exclusion simply reduced the tax burden associated with selling a home at a huge profit. But for the wealthiest of homeowners-those who own multiple properties-the exclusion was being used as a tax-planning strategy that could generate large amounts of regular, tax-free income. The game worked like this: first, the homeowners sell their primary residence and take the exclusion. Then, they move into one of their vacation properties. After two years, the second property then qualifies as a primary residence. The homeowners then sell that property and take the exclusion again, raking in more tax-free income. This game of house hopping could go on until the homeowners had sold off all their real estate, tax-free.
Changing the game
Beginning in 2009, wealthy homeowners' access to tax-free real estate gains will be more limited. The change, which is incorporated into the housing stimulus package, ties the exclusion amount to the length of time that the home is actually used as a primary residence. To demonstrate, let's say homeowners Bob and Sue Jones buy a second home for $400,000 in 2009. Two years later, they move into that home and use it as their full-time residence for two years. In 2013, the couple pack up and move to Tahiti, selling their home for $800,000. Under the old rules, the entire $400,000 gain could have been excluded from their taxable income, because they lived in the home for two years, and they hadn't taken the exclusion in the year prior. But now their exclusion is limited to $200,000, because they only used the property as a full-time residence for two of the four years they owned it.
The new law takes some of the fun and financial gain out of the vacation home hop. Homeowners of multiple properties, and even those who are considering buying a second or third home, should discuss their options with a qualified tax advisor. Otherwise, they won't be singing hopscotch rhymes-they'll be belting out the tax bill blues.