Changes to the $250,000/$500,000 Exclusion For 2nd Home Sellers

Source: Sarasota Realtor Magazine February 2009
Author: Marc Mansfield – Government Affairs Director

This is a very informative article regarding the changes in tax implications for a second home purchase.  In 2009, there are some new rules placed into effect as a result of the 2008 Housing and Economic Recovery Act when a second home is converted to a principle residence. Here are some explanations and examples of how this new rule impacts second home sellers.

Governmental Affairs

When a former second home is sold, some portion of the gain may be taxable, even if the owner has lived in the home for the required two of the previous five years. The examples below illustrate the application of this new rule.

Example 1: Post 2008 Purchase and Sale: Charlie, whose tax filing status is single, bought a vacation property costing $400,000 on March 1, 2009. On March 1, 2012 he converts the property to his principal residence. On March 1, 2014, he sells the property for $700,000, realizing a gain of $300,000. He has owned the property for 5 years and used it as a principal residence for 2 years. On these facts, 40 percent of the gain (2/5) is eligible for the $250,000/$500,000 exclusion (2 years use as a principal residence divided by 5 years of ownership. The remainder of the gain (60 percent: 3 years as non-principal residence/5 years of ownership) will be taxed at capital gains rate that applies in the year of the sale. Of the total $300,000 gain, $180,000 ($300,000 x .60) will be treated as a capital gain. If the capital gains rate in 2014 is still 15 percent the total tax would be $27,000 ($180,000 x .15) Since the remaining $120,000 gain is less than $250,000, $120,000 is eligible for the exclusion.

Example 2: Pre 2009 Conversion to a Principal Residence: Fred and Ethel bought a condo that they have used solely as a rental property since 1989. They decided to simplify life by selling their house and moving into the condo. They moved into the condo on April 15, 2008. In April 2019, they sell the condo. They have a very low basis in the condo because it was used as a rental property for 19 years (1989-2008), leaving them a gain of $600,000. When they sell the condo, they will be eligible for the $500,000 exclusion because the property was their principal residence on January 1, 2009. In this case they will pay tax on the $100,000 excess over the $500,000 ($600,000 gain minus $500,000 exclusion) at the capital gains rate effective for 2019. In addition, they will be liable for the depreciation recapture taxes for the years that the property was used as a rental property. The depreciation recapture tax will be imposed at the rate effective for 2019. The current rate is 25 percent.

Example 3: Pre 2009 Purchase and Post 2008 Sale: John and Susan, who file a joint return, bought a vacation property in 1985 for $100,000. During the years they have owned it, they have used it solely as a vacation home. On January 1, 2011, they move into the home and begin to use it as their principal residence. During the time they have owned the home, they have added $125,000 in improvements. The community where it is located is now a major tourism and resort area and they have enjoyed significant appreciation as well. In 2020 they sell the home for $1 million. Their taxable gain and exclusion are as follows:

Total amount of gain – $775,000 ($1 million selling price minus original costs of $100,000 and improvements of $125,000). Taxable post 2008 gain – This is the number of years AFTER 2008 that the property is NOT used as a principal residence, divided by the total period of ownership: Number of non-residential years – 2 (2009 and 2010 Number of years of ownership – 35 (1985 – 2020) Taxable Gain – 2/35 x $775,000 = $44,285 Tax on non-residential use – $6,643 (assuming 15 percent capital gains rate) Exclusion – Remaining gain $730,715 ($775,000 minus the $44,285)