Strategy: Point out the benefits of converting a second home into a main home as soon as possible.
Reason: Under the proposed legislation, your clients might miss out on a tax-free bonanza for the post-2007 sale of a converted home. Currently, a client can claim the full home-sale exclusion when he or she sells a second home that has been converted. The proposed law will affect the gain exclusion only if the homeowner uses the home as a vacation home or an investment property after 2007. So clients still have time to get in under the wire.
Background information: If a taxpayer owns and uses a home as his or her principal residence for at least two of the five years prior to a sale, the taxpayer can exclude up to $250,000 of the resulting gain from capital gains tax. The exclusion doubles to $500,000 for joint filers. Even better, the IRS imposes no current limit on the number of times a client can claim the $250,000/$500,000 home-sale exclusion. All the taxpayer has to do is meet the two-out-of-five-year requirement. Theoretically, someone can cash in multiple times during his or her lifetime. If a client owns a second home—such as a vacation home near the water or in the woods—he or she may first sell the main home at a tax-free profit. Then the individual can establish the second home as the principal residence. After two years, the homeowner could sell the “second home” and claim the home-sale exclusion again.
Example: Jerry Greenspan sold his principal residence for $750,000 in 2004. Its adjusted basis was $300,000, so he excluded $450,000 from tax. In 2005, Jerry moved full-time into his “winter place” at a warm-weather site. The winter home has a basis of $250,000 and is currently worth $600,000. If Jerry sells it now, his $350,000 gain will be tax-free because he has lived in the home as his principal residence for more than two of the five years preceding the sale. With the two home sales, Jerry will have collected $800,000 of home sale profits without paying any tax.
Dark cloud: The proposed law won’t allow someone to claim the full exclusion if he or she sells the second home after converting it into the principal residence after 2007. Instead, the individual will have to pay tax on a portion of the gain, based on the percentage of the time the home was used as a vacation home or rented out before the sale. The remainder of the gain will be tax-free so long as the individual still meets the two-out-of-five-year rule (see box, above).
The proposed law applies to sales made after 2007. But any period of vacation home use or rental use occurring before Jan. 1, 2008, won’t count against your clients. So the sooner they can move their digs, the better.
Advisory: Remind clients to keep records that can establish a change of principal residence.
Figure out the tax equation
The gain exclusion that would otherwise apply is reduced by multiplying it by a fraction based on post-2007 usage for purposes other than as a principal residence, divided by the total ownership period.
Example: Say your married client has owned a residence for 10 years when he sells it at the beginning of 2013. For 2003-2010, he uses the property as a vacation home. For 2011 and 2012, he uses it as his principal residence. The $500,000 gain exclusion amount that would otherwise apply is reduced by $150,000 (3/10 x $500,000 = $150,000) to account for the three years of post-2007 usage as a vacation home (during 2008 through 2010). So the reduced exclusion when he sells the home in 2013 is only $350,000.
However, if he converts the property into a principal residence before 2008 and uses it as such for at least two years before selling it, the full $500,000 gain exclusion will be available when the property is sold.
Reprinted with permission from The Tax Strategist, December 2007. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus Reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.