New Law For Capital Gains Tax In 2009

CRS, GRI, SRES, e-PRO Realtor® Associate

CHANGE IN FEDERAL TAX ON SALE OF RESIDENCE

As we all know, when homeowners sell their principal residence, they can exclude up to $250,000 (or up to $500,000 for married couples filing jointly) of capital gains from income tax. However, a little-noticed provision in the Housing Assistance Tax Act of 2008 changes the rules: The amount of profits from the sale of a house that can be excluded will now be based on the percentage of time when the house was used as a primary residence by the taxpayer.

Under these new rules which will take effect beginning January 1, 2009, the amount of gain that will qualify for the exclusion is limited based on the amount of time that the house is actually used as a primary residence. If the house is used other than as a primary residence (such as rental property, or a vacation or second home), capital gains must be allocated between qualifying and non-qualifying use.

Qualifying Use vs. Non-Qualifying Use

To qualify for the $250,000/$500,000 exclusion, the person needs to own and live in the property as his or her primary residence for at least two years out of the five years ending on the date of sale. Under the new rules, the time that the taxpayer owns the home will be divided into “Qualifying use” and Non-qualifying use.”

Qualifying use means the property is being used by the homeowner or the homeowner's spouse as a primary residence.

Non-qualifying use means the property is not being used as a primary residence by either the homeowner or the homeowner's spouse.

Calculating Excluded and Non-Excluded Gain on the Sale of a Home

Gain from the sale of a home may need to be allocated between what gain is excluded and what gain is not excluded. The portion of capital gains that cannot be excluded is determined by the following ratio:

Period of non-qualifying use
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Period of total ownership

Calculating the Time Period of Non-Qualifying Use

For the purpose of calculating capital gains, the period of non-qualifying use is any period of time the property is not being used as the primary residence that begins on or after January 1, 2009.

Non-qualifying use prior to January 1, 2009 is disregarded for the purpose of determining the capital gain allocation.

Temporary absences not exceeding a total of two years in aggregate will not jeopardize qualifying use. A property can maintain its status as a primary residence even if the homeowner is absent due to change in employment, health conditions, or other unforeseen circumstances.

Example of Allocation Under the New Law

For example, suppose that you are a single taxpayer and you buy a house on January 1, 2009 for $800,000. You rent it out for two years and, during that time, write off $40,000 in depreciation deductions. Then, two years later on January 1, 2011, you convert the rental house into your principal residence, and live there for two years. On January 1, 2013, you move out and put the place up for sale. On January 1, 2014, five years after you purchased it, you complete the sale of the house for $1,200,000.

As it is under current law, the $40,000 of depreciation write-offs is treated as gross income.

But, these new rules allow the three years of use as a principal residence to only qualify you for some portion of tax-free exclusion on the $400,000 gain. But how much?

To figure it out, you divide the aggregate period of non-qualified use (the two rental years) by the total period of ownership (five years) and multiply that fraction (two-fifths or 40%) against your gain of $400,000. The resulting number is the amount that's subject to capital gains taxation -- $160,000 in this case. The remaining $240,000 is tax-free.

Homeowners who have used the property exclusively as their primary residence will not need to allocate their gain.

PRACTICE TIPS

1. Do not give tax advice to your clients. Do not forward this Tip to your clients. This is for your background information only.

2. Commencing January 1, 2009, the exclusion of up to $250,000 (or up to $500,000 for married couples filing jointly) in capital gains from income tax will be based on the period of time when the property is used as a primary residence. Any other use will not be excluded and could trigger capital gains tax.

3. Taxpayers owning second homes, vacation homes, and rental properties will need to revise their capital gains strategy accordingly.

4. Property owners with rental, vacation or second homes should seek tax planning advice from their tax advisors. Taxpayers planning to sell a second home may want to consider moving in and making that property their primary residence starting January 1, 2009, to gain as much qualifying use as possible before selling it. But, they should talk to their tax advisor before making any move.