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Federal tax changes affect gain on sale of second homes

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The U.S. Government did a great thing for homeowners back in 1997.  The Taxpayer Relief Act allowed a homeowner to exclude up to $250,000 of gain on a residential sale.  Married homeowners filing jointly could exclude up to $500,000 of gain.

Tax-free profit - that's hard to beat.  Many of us were able to use the exclusion and sell a property, then upgrade to a better home.  With our economy going the way it is (not so good), Congress is making some changes that will affect the home sale exclusion.

As the law is currently written, a homeowner must reside in the residence for two out of the last five years.  Meeting this test allows the homeowner to take the full exclusion.  The gain exclusion can be used once every two years.This means a homeowner could theoretically own two houses, living in a residence for two years then moving to the next one and selling the first for a tax-free gain.  With the proceeds from the first home sale, he could buy another house, etc.

Beginning January 1, 2009 the rules will change.  From that day forward, the exclusion will be limited to "Qualified Use" - that is, the time the owner resided in the home.  When a home is used as a rental or vacation home, that period will be considered "Non Qualified Use" and subject to taxable gain.

Here's an example: A couple buys a home on January 1, 2009 for $500,000.  They live in the home two years and rent it out for one year.  The house is sold on January 1, 2012 for $1,000,000.

- Under the old law, the couple met the two out of five year requirement and their gain would be excluded from capital gains taxes.

- Under the new law, the couple would have 1/3 (one out of three years owned) of the gain taxed at capital gains tax rates.  Two thirds of the gain would remain tax free. 

The new law is still good for homeowners, just not as good as it used to be!

Properties purchased prior to 2009 then sold 2009 or later

The period a property was owned prior to January 1, 2009 is not subject to the allocation.  In other words, it's not taxable for capital gains if the owner met the "two out of five" criteria.

Example: A couple bought a home on January 1, 2005 for $300,000.  They use it as a second home and make it their primary residence on January 1, 2010.  Two years later, they sell the home for $1,000,000.   

The couple has met the "two out of five" criteria for gain exclusion.  But for the year 2009 the house was their second (not primary) home.  That one year out of eight that the couple owned the home makes the fraction for calculating their taxable gain 1/8 X $500,000 gain =  $62,500 to be taxed at capital gains rates.

Summary of the tax law relating to sales of residential properties

This is a complicated issue - let's start from the beginning.

  • If a single person lives in a home for two out of the last five years and owns it for at least two years, he can exclude up to $250,000 in gain on the sale of that residence.

     

  • If a married couple filing a joint return meets the same criteria (both must have lived in the home two out of the last five years) they can exclude up to $500,000.

     

  • If the owners live in the home (for two out of the last five years) and then rent it out or use it as a vacation home and sell the property by December 31, 2008, they still get the full gain exclusion.

     

  • If the owners live in the home (for two years out of the last five) and then rent it out or use it as a vacation home and sell the property AFTER December 31, 2008, the period after 12/31/08 (when the property is a rental or second home) until the time the property is sold is considered "Non Qualified" use and the property becomes subject to the allocation. 
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  • The period that a property is used as a vacation home or rental up to 12/31/08 does not become a problem (does not create a taxable gain) as long as the couple has lived in the home for at least two out of the last five years.
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  • For those of us who own just one real estate property and use it as a principal residence, after you've owned and lived in the home for two years you can exclude your capital gain the same way as before!  It only gets difficult when owners move out of their home and sell it later at a gain.

Realtors: If your seller is looking at offers and contemplating, it is important for them to know this tax law if it affects them!  Understanding the rules might help us get a few more sales by the end of 2008.

Prospective sellers: Check with your tax attorney or CPA.  Other factors not discussed in this article may affect your decision and the amount of taxable gain on your transaction.

Aloha, Mike

Comments (27)

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Mary King

I purchased a condo in Maui in June 2004 with the intent that it would become my retirement home. I rented it out without ever living in it as I was still living and working in California. I did not own a residential property in California and now that I am retired I had intended to move to Maui and live in the condo, and eventually sell it to pay for an assisted living facility when I reach that stage of life. If I live in the condo equal to or longer than the time it was a rental, would I still lose my $250,000 exemption? Anyone have an opinion?

mikey

Hi Mary,

In your case, the "non-qualified use" clock started ticking on January 1st. If you move to Maui and start living in the condo in the next couple of months, wait two years and you should have most of your $250,000 exclusion intact. The longer you put off moving in (after January 1, 2009) the longer you will have to stay in the condo to recoup the gain exclusion.

There are other factors involved. For example, when you're ready to sell, where will the market be? Right now the market is soft, although I imagine your condo's value is still above what you paid for it. Two or three years from now, hopefully the real estate market will be back to steady growth and you'll have lots of equity to cash out on and use for the assisted living facility.

If your anticipated gain when you sell is substantiall less than $250,000, the allocation of gain might not even be a factor.

Check with your personal tax advisor before making a decision as individuals have their own unique tax situations.

Aloha, Mike

bryan

We purchased a home #2 in the spring of 2007 that needed remodeling. Finally completed the remodel in the fall of 2008. In the meantime we were attempting to sell home #1 without success during the downfall in the real estate market. We moved into house #2 in nov. 2008 and rented out house #1 in March 2009.

House #1 was purchased in 1996 for $250,000. It has appreciated to approximately $500,000 today.

How long do we have to sell house #1 until we lose the tax exclusion?

If i'm understanding this right, will i have to pay capital gains tax on house #1 during the period of time between jan. 1, 2009 and the time the house #1 sells?

if I do not live in house #1 for the last 2 out of 5 years do i loose all tax exclusion or just a part of it?

Thanks, Bryan

mikey

Hi Bryan,

Have you lived in house #1 for two out of the last five years? If the answer is yes, then you and your wife ("we" sounds like you're married) have a $500,000 gain exclusion.

Starting on January 1, 2009, that exclusion slowly erodes for the time it's used as a rental property. Since you have about a $250,000 gain if you sell it today, it sounds like there will not be a large capital gains tax to pay.

For example, If you rent house #1 out for all of 2009 and you lived in it from 1/1/96 to 11/30/2008, the fraction of gain that's taxable would be about 1/14th. Math: $250,000 x 1/14 = $17,857 times your capital gains tax rate.

If you don't live in house #1 for at least two out of the last five years, you lose all of the gain exclusion.

Check with your CPA to verify, there may be other factors that could come into play.

Aloha, Mike

Bill

I bought my house # 1 in June/1996. I moved out into house #2 in April of 2005. I am trying to sell house # 1 in 2009. Last april was 3 years since I moved out of house #1. The capital gain is approx. 300K. What is the gain exclusion??

Thanks

Bill

mikey

Hi Bill,

If you April 2008 marked 3 years since you moved out of the house, then you no longer meet the "two out of the last five years" criteria and generally there is no gain exclusions.

There are some exceptions for hardships, such as loss of job. Don't push it though, if you didn't really have a hardship I would not try and use that reasoning for an exclusion. Instead, if feasible you might want to move back into the house for a time until you've reached 2 out of the last 5 years again and then the exclusion should be in place.

Aloha, Mike

Pete

I bought house number 2 as an investment in 2005 for 60k, took out a second mortgage for 75k to fix it up. Sold it in 2009 for 135K. do I have capital gains on this house?

mikey

Hi Pete,

House 2 - $60k + 75k = $135k appears to be your basis. If you took no depreciation, then your basis equals your selling cost and there's no capital gain. On top of that, you probably had selling expenses (commissions, escrow fees etc.) to deduct and then you might have a tax deductible loss.

Please consult with a tax professional as each person's tax situation can be different. State taxes vary as well.

Aloha, Mike

Ron, NY

I have a second home bought for 120k in 1984 and put about 50k in over the last several years. It's current estimated value is $500,000. How much capital gains would I pay on the 330,000 in profit? I live in New York City

.

mikey

Hi Ron,

Maximum capital gains rates are currently 15%. You may have $49,500 in Federal tax due upon the sale.

Other factors: 1) Have you depreciated the home in the past 25 years? If so, your basis will be reduced by the prior years' depreciation expense which will increase your gain. 2) Selling a home usually generates selling expenses such as commissions, advertising, termite inspections, etc. These can reduce your taxable gain.

Please consult with your CPA or Tax Attorney regarding New York City / New York State taxes.

Taxes are a consideration when selling a home. More importantly, you are able to sell for a profit. A lot of other people are unable to do that at this time.

Aloha, Mike

Sarah

My fiance and I are buying the house we currently rent from my mom. It was my grandmother's and the house my mom grew up in. We're going to continue to pay my mom, interest free, monthly payment towards the house. Interest free seller financing. We'll have a contract of deed and go through our lawyer.

Now we are first time homebuyers. I am not eligible for the credit as it is my mom but my fiance is if we put the house completely in his name until 2010 is over and we're married.

My question is, what are the ramifications for my mom and her taxes? Does she need to claim anything? She won't be getting any interest to claim as income. Will she have to pay any capital gains? The house is only $200,000. When she got it from my grandmother when she passed it was worth more then than it is now. I want to make sure that this is a win/win for everyone involved and no one is getting screwed over.

Steve

We brought our first home in 1979 and lived there for 2 years. Since then it has become a rental. If we move back into it for at least 2 years and then sell it, how does that affect capital gains exemptions.

Patti Totten

My mother quick claimed her home to me and two sisters in October of 2002. One of my sisters has passed away since then and the two remaining are selling it now. The home was purchased for $133,000 and hopefully will sell for about $225,000. We have just let friends and family use the home since my Mothers passing in 2006. What Capital gains will we be responsible for, also how do we file considring both my sister and I are married?

Thanks Patti Totten

mikey

Hi Steve,

From January 1, 2009 to the day you convert it back to owner occupied, will be the part of the fraction that is subject to capital gains.

For example, let's say you moved back and began occupying the home on January 1, 2010. You live there two years, until December 31, 2012. That makes three years of ownership since the new law took effect. Two of the years (when you lived there) would be exempt from capital gains and one year would be subject to capital gains. Therefore 1/3 of your total capital gain would be subject to tax and 2/3 would be excluded.

Aloha, Mike

mikey

Hi Patti,

You have not earned any owner occupant exclusion so it does not come into play.

Your questions are complicated. For one thing, what was the tenancy of the three sisters? Did the deceased sister pass her share of the home onto her heirs (kids, husband) or did the tenancy have rights of survivorship so that only you two sisters own it now?

The home was purchased for $133,000, what year was that?

At the time your mother passed away, the value of the home became the new basis for you and your sisters. Was it 2002 or later?

For an example, let's suppose she passed away several years later and the appraised value at that time was $150,000. If that's the case, your selling price of $225,000 less basis of $150,000 = $75,000 gain. Selling expenses (sales commissions, escrow fees etc.) reduce the gain further. Then that taxable gain will be divided amongst the inheritors of the home. If it's just two of you, the taxable gain is split in half.

Escrow would issue each of the owners a 1099. Your gain on sale would be computed and apportioned amongst you.

Please see a CPA or tax attorney.

Aloha, Mike

Cymantha

My parents purchased their home in California in 1952 for ~ $7,000 and lived in it until they were both moved into an assisted living residence in March 2009. The house has been vacant since then and they will not be moving back into it. The house is probably worth ~$150,000 today. 1.) Is it true that in assisted living situations they only have to live in the home 1 of the last 5 years, ie. you have 4 years to sell from the date they moved into assisted living before losing the capital gains exclusion? 2.) If the home is rented out but they sell before the exclusion expires how is the gain calculated? 3) If the home stays a rental until both of them pass away, does the basis step up upon the last person's death?

mikey

Hi Cymantha,

Those are good questions, I had to go look them up!

Were your parents disabled? If they were, then they only had to live in the house one year out of the last five. If one parent is disabled and the other is not - my guess is that the disabled person would get the capital gain exclusion ($250,000). That would be enough to avoid Federal capital gain taxes on a $150,000 sale price. If neither parent was disabled then they might not be eligible for the gain exclusion.

If the home was rented out after December 31, 2008, the capital gain calculation will take that into account. Your parents owned the house for such a long time, the capital gain would most likely be small. Consult with your CPA or tax attorney to determine the amount.

Yes, if the property passes and is inherited by someone else, they will get the stepped up basis. If, as we discussed above your parents are no longer eligible for the gain exclusion, the best route might be for them to retain title and pass the property on to their heirs. There are certain exceptions, please see IRS Publication 523.

Aloha, Mike

Jay Weidemoyer

My wife and I purchased a 2nd home near a college in Scranton, Pa. for our daughter to live in when she went back to school for her masters degree in 2006. We paid $75K and we borrowed $120 for the cost of the house and renovations. We are looking to sell it this year for $145K. We have receipts for approximately $45K for renovations. I did 75% of the labor on the home. What kind of capital gains tax should I expect to pay ?

Thank you for your help,

Jay

mikey

Hi Jay,

You borrowed $120k to buy the house and renovate. Selling at $145k less commissions and closing costs will probably net you about $135k. Subtract the $120k financed and that leaves about $15k subject to capital gain. I think your federal capital gain tax would be 15% or less (on $15k).

Since you did not live in the home for two out of the last five years there is no capital gain exclusion.

Your "sweat equity" cannot be added into your adjusted basis. It was "free" labor. At least you didn't have to pay someone else for it!

Aloha, Mike

stephen belansky

Hi Mike,

I have a rental home that I purchased in 2009. If I sell it, would there be federal capital tgains on it. It is considered a long term investment and my wife and I are in a 10% tax bracket

Thanks, Steve

mikey

Hi Steve,

The first thing to figure out is if you will have a capital gain at all. Will your selling price, minus expenses (commissions, escrow fees etc.) exceed your basis? (Basis is the price you paid for the home plus expenses).

If the answer is yes, you may have a taxable gain. The tax will be on your net gain, not on the selling price. If we're talking about something like a $200,000 sale for a home you paid $175,000 on, the capital gain tax might not be a lot.

Aloha, Mike

stephen belansky

mikey; thanks for getting back to me. i built the house in 2009 and rented it. i am in the process of selling it for 210,000. i am into it for 130,000. do you know how much federal capital gains i would pay?

THANKS, STEVE

mikey

Hi Steve,

The only way to know for sure is to look at your entire tax situation. Your CPA can best answer your question.

Ballpark - $210k - $130k =$80k. Subtract $13k for commissions and selling expenses = $67k. Multiply times 10% = $6,700 Federal tax.

There are a lot of things that can change this figure and your total taxes also depends on which state you live in.

Aloha, Mike

glenn edwards

Purchase home in 1988 for 64K, remodeled 1999 for 30K, claimed depriciation for only 5yrs, lived in the house from 88-90, 91-95 and 97-2001. I was in the Marine Corps and only moved due to transfers. Rented the house out each year while relocating to new duty station. House has been empty since 2007, can I claim it as primary resident even though I own 2 others? Also, what would be the most I would pay in capital gains tax?

melany

Hi Mike,

My husband and I purchased our first home in February 1999 for $57,000. In August 2009, we found a much needed larger home for our growing family of 6. We put the old home on the market (for $80,000) and began the buying process for the new home. We moved out of the old home in November 2009, a week after closing, and into the new home. The old home has been on the market ever since with no bites until now. (It has never been used for business or rental; its been vacant.) We now have an offer for asking price. What are the consequences for us regarding the sale of the old home and capital gains taxes?

Thanks,

Melany

mikey

Hi Melany,

From the day you moved out in November 2009 to the day the home sells - that period will probably be deemed as not excludable from capital gains since you had a new primary residence that you moved into.

If the old home sells for $80,000 your capital gain might be less than $20,000 after paying commissions and closing costs. You were in the home for 10 out of the last 11 years so the fraction of gain that might be taxable is about 9% - or about $1,800. Your capital gain tax on that is likely to be small, perhaps a couple of hundred dollars.

Aloha, Mike

mikey

Glenn,

Sorry your comment slipped through and I'm answering it two months late. You haven't lived in the home since 2001, it cannot be claimed as your primary residence.

I cannot estimate your gain as I don't know what your sale price would be on the home.

Aloha, Mike

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