Real Estate
Congress Changes the Capital Gains Exclusion Rule for Home Sellers
The Housing and Economic Recovery Act of 2008 included some changes for the capital gains exclusion rule for home sellers. It bears noting up front, though, that if you sell any principal residence in 2008 or, after that, a principal residence that was never rented out after 2008, this change will not affect you.
The change in the rule targets the treatment of capital gains on a home that was used both as a primary residence and as a rental or vacation home. Prior to the change, an owner could move into a secondary property for two years, satisfying the requirement of occupying the property for 2 out of the last 5 years, and then sell that home, claiming a full capital gains exclusion of $250,000 (or $500,000 if married filing jointly).
Savvy property owners were in some cases moving into their other properties for 2 years, selling, and then moving on to another property to repeat the process. Those leapfrogging days are over. The Housing and Economic Recovery Act of 2008 seeks to close this "loophole" by including a provision that splits the capital gain into two parts based on a ratio. No exclusion is allowed on the portion of the gain that is due to "non-qualified use," which is defined by the Act as any usage during which the taxpayer owned the home but did not use it as a primary residence. The rest of the gain will remain eligible for the up-to-$500,000 exclusion, as long as the 2-out-of-5 year occupancy requirement is satisfied. (See below for a discussion of one of the exceptions to the general definition of a "period of non-qualified use.")
Non-qualified use begins to accrue on Jan. 1, 2009 for property that is not a principal residence, so past usage as a rental or a vacation home generally does not impact taxes on capital gains. Future usage may or may not impact taxes, and the rules of the Act can be confusing and complicated. We give examples of two specific property-ownership scenarios to illustrate the effects of the rules. In both scenarios the owners bought their home in 2003 and sell their property in 2013, with net profits of $400,000.
In Scenario 1, John and Jane Resident have lived in their home as their primary residence, but decide in 2011 to move elsewhere and rent out their former residence for two years until its sale in 2013. That situation falls under one of the exceptions in the rules, and the entire $400,000 of capital gain can be excluded from taxes.
In Scenario 2, Lisa and Larry Landlord lived in their home from 2003 until 2009, rented it out for two years, and then returned to it as their principal residence from 2011 until the sale in 2013. The two years in which renters occupied the property is a period of non-qualified use. The other eight years of ownership are qualified use and allow the Landlords to exclude 80% of the $400,000 gain. Their tax return for 2013 includes capital gains of $80,000, which is 20% of $400,000, because non-qualified use occurred during 20% of the ownership period.
While the two scenarios had the same number of years for the property as a residence and as a rental, the order of the residential and rental periods matters. The chart shown below illustrates the two scenarios.
If you own rental or vacation property and had planned to maximize your after-tax profits from sale using the 2-out-of-5 year occupancy strategy, you should be aware that Congress has changed your plan to a potentially less profitable one.
Illustration of Periods of Residential and Rental Use for Scenarios of Capital Gains Exclusion
| Label | Period 1 | Period 2 | Period 3 |
|---|---|---|---|
| Scenario 2 | 2009 | 2 | 2 |
| Scenario 3 | 2011 | 2 | 0 |
