New Tax Law Affects Capital Gains for Second Homes turned into Primary Residences

We were having a discussion yesterday with one of our investor clients whether or not he and his wife should downsize and move from their primary single family residence, benefit from the capital gains exclusion ($500,000 in profit exempt from taxes for a married couple filing jointly), and move into an investment condominium they own and have held for investment for many years.  In the past, this couple could sell their primary residence, reap the capital gain, move into the condo, live there for two years, then turn around and sell the condo after 2 years and little or no capital gains. 

Well, no more.  According to the Wall Street Journal, Congress has changed the rules on this starting in 2009,  What does this mean for sellers plan to turn second houses that they own into primary residences to benefit from the capital gain exclusion?

The old rule, around since 1997, gave homeowners a capital gains exclusion of $250,000 for a single filer, and $500,000 for a couple filing jointly.  One only had to live in their house for 2 out of the 5 years of ownership to qualify for the entire exclusion.  A seller could buy an investment property, hold it as an investment for a few years, then move into it for just two years as a primary residence to qualify for the full exclusion. They could then turn around and sell, taking advantage of no capital gains.

Under the new rule which starts January 1, 2009 and applies to second home purchases moving forward, the homeowner cannot take the full exclusion for capital gains purposes if they have held it partly for investment and partly as a primary residence. For example, if our couple purchase a vacation house in Narragansett for $600,000 in 2009, rent it out for 3 years, move in as a primary residence in 2012 for 2 years, then sell in 2014 for $1.1 Million (a profit of $500,000), only two fifths ($200,000) would be exempted from capital gains.  The remaining three fifths would be considered attributable to the three years the home was not their principle residence.

The government estimates that $1.4 billion will be raised from the change in this loophole over the next ten years. 

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