This article was published on: 1/16/2009
SILVAR

New Rules for Taxing Gain When a Second Home is Converted to a Principal Residence.

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.  (As in the past, gains above the exclusion amount remain taxable.)

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 the gain, be eligible for part or all of the $250,000/$500,000 exclusion.

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 or as a second home.  The denominator of the fraction will be the total number of years of ownership, dating from the original purchase date.  No appraisals will be required and people who have held properties for a long time will not suffer any disadvantage.

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.  Thus, the new rule allocates the exclusion only to use 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 after 2008 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.

The formula does not penalize individuals who own non-principal residence property before 2009.  After 2008, when a second home is converted to a principal residence, the rule of thumb will be that the longer the period of use as a principal residence, the greater the amount of the excludable gain.

Taxable Gain Rule Change Examples

Example 1: Post-2008 Purchase and Sale

Carson, whose tax filing status is single, bought a vacation property costing $300,000 on March 1, 2009.  On September 1, 2011, he converts the property to his principal residence.  On March 1, 2014, he sells the property for $1,000,000, realizing a gain of $700,000.

Carson has owned the property for five years (60 months) and used it as a principal for 30 months.  Based off these facts, 50 percent of the gain (30 out of the 60 months) is eligible for $250,000/$500,000 exclusion (30 months of use as a principal residence divided by 60 months of ownership).  The remaining 50 percent of the gain will be taxed at the capital gains rate that applies in the year of sale.

Of the total $700,000 gain, $350,000 ($700,000 x .50) is automatically treated as a capital gain.  Since the remaining $350,000 of gain is more than the $250,000 exclusion, an additional $100,000 is included in capital gains.  $250,000 will be eligible for the exclusion and $450,000 is taxed as capital gains.

Example 2: Pre-2009 Purchase and Post-2008 Sale:

Matt and Brynn, who file a joint tax return, bought a vacation property on March 1, 1999 for $300,000.  During the years they have owned it, they have used it solely as a vacation home.  On September 1, 2011, they move into the home and begin to use it as their principal residence.  During the time they have owned it, they have added $125,000 in improvements.  The community where it is located has become a major resort, so they have enjoyed significant appreciation, as well.

On March 1, 2014, they sell the home for $1,000,000.  Their taxable gain and exclusion are as follows:

Total amount of gain: $575,000 ($1,000,000 selling price minus original cost [$300,000] and improvements [$125,000]).

Taxable post-2008 gain: This is the number of months AFTER 2008 that the property is NOT used as a principal residence, divided by the total period of ownership:

Number of non-residential month: 32 (1/1/09-9/1/11)
Number of months of ownership: 180 (3/1/99-3/1/14)

Taxable gain: 32/180 x $575,000= $102,222
Tax on nonresidential use: $15,333 (assuming 15 percent capital gains rate)

Exclusion: Remaining gain: $472,778 ($575,000 - $102,222)
Excludable amount: $500,000
Remaining taxable amount: $0 ($472,778 - $500,000)

Example 3: Pre-2009 Conversion to Principal Residence:

Reggie and Kim bought a townhouse as a rental property in 1999 for $300,000.  They decided in 2008 to sell their house and move into the townhouse as their principal residence.  They move in on October 21, 2008.  In October of 2014 they decide to sell the townhouse and receive $1,000,000.

They realize $700,000 in gain from the sale of the townhouse.  Since they converted the rental property to a principal residence prior to December 31, 2008, they are able to realize all of the gain, up to the exclusion levels.  Therefore, Reggie and Kim will be allowed to exclude $500,000 from the $700,000 gain and only have capital gains tax on the final $200,000 of gain.

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