Selling Your Home

Most homeowners are aware of the home sale exclusion, a provision of the tax laws which provides that homeowners who sell their principal residence typically don't need to pay taxes on as much as $500,000 of their gain if they meet certain conditions. (The $500,000 exemption is the maximum exclusion for a married couple filing jointly; taxpayers filing individually get an exemption of up to $250,000.) To be eligible for the full exclusion, a taxpayer must have owned the home—and lived in it as his or her principal residence—for at least two of the five years prior to the sale. Because of the “principal residence” requirement, vacation or second homes normally don't qualify for the exclusion. However, in what some saw as a loophole, the law permitted taxpayers to convert their second home to their principal residence, live in it for two years, sell it, and take the full $250,000/$500,000 exclusion available for principal residences, even though portions of their gains were attributable to periods when the property was used as a vacation or second home, not a principal residence.

The new law closes that “loophole” by requiring homeowners to pay taxes on gains made from the sale of a second home to reflect the portion of time the home was not used as a principal residence (e.g, vacation or rental property). The amount taxed will be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The new law in effect reduces the exclusion based on the ratio of years of use as a principal residence to the total time of ownership. For example, if a taxpayer owned a vacation home for ten years, but lived in it as a principal residence only for the final two years prior to sale, the maximum available exclusion would be reduced by four-fifths. Accordingly, a $400,000 gain on the sale that would be eligible for the full exclusion under pre-Act law would be reduced by four-fifths, to $80,000.

The good news for current owners of second homes is that the new law is not retroactive. The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of the provision. Also, the new law doesn't change the rule that allows homeowners to take advantage of the home sale exclusion every two years. Taxpayers can still “home hop” with full tax exclusion if they only own one home at a time. Moreover, the taxpayer still qualifies for capital gain treatment on the amount of gain that cannot be excluded.

 

Selling Rental Property

The following discussion of the tax consequences assumes that (1) your income, other than amounts treated as capital gain, is taxed at a marginal rate of at least 25%, and (2) the real estate sold is the only business asset sold by you in the tax year of the sale.

Generally, the gain from the sale by a noncorporate taxpayer of real estate that is a capital asset (or is used in a business) and is held more than 12 months isn't taxed at a rate higher than 15%.

But a more complex set of rules comes into play when the asset sold is depreciable real estate. This is so because, in that case, a maximum rate of 25% will apply to what's called unrecaptured section 1250 gain and a maximum rate of 15% will apply to the balance of the gain. “Unrecaptured section 1250 gain” refers to the portion of gain that is eligible for capital gain treatment even though it is attributable to previously allowable depreciation. A further complication is that the portion of the gain that is unrecaptured section 1250 gain depends, as shown below, on when the property was placed in service.

For real estate placed in service after 1986, all depreciation deductions allowable before the sale of the real estate give rise to unrecaptured section 1250 gain. Thus, if you sell, at a gain of $200,000, a building on which $90,000 of depreciation deductions were allowable to you through the time of sale, $90,000 of the gain is unrecaptured section 1250 gain that will be taxed at a rate of 25%. The remaining $110,000 of the gain will be taxed at a rate of 15%.

Beginning last year 2008 and continuing through 2010, a zero tax rate applies to most long-term capital gain that would otherwise be taxed at the regular 15% rate and/or the regular 10% rate (last year, a 5% rate applied to such income).  The amount of income taxed at 0% depends on the interplay between an individual's filing status, his taxable income, and how much of that taxable income consists of long-term capital gain.