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Potential Tax Hit for Sellers of Vacation Homes

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Real estate owners get a number of tax breaks from the IRS, both while they own the residence and after they sell it, to a point. In the first of a two-part series, Julian Block discusses how the current rules work for vacation home sellers, as well as times they might take a hit on their income taxes.

Sep 2nd 2021
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Back in 1997, a bi-partisan Senate and House cut a deal with President William Jefferson Clinton. They overwhelmingly passed and he signed legislation that amended Section 121 of the Internal Revenue Code. 

The amendment introduced rules that allow home owners to sidestep taxes. Owners are able to “exclude” (IRS lingo for escape) taxes on sizable portions of profits from sales of main residences. Section 121 doesn’t permit sellers to claim unlimited profit exemptions. It imposes caps that are based on filing status. 

The exclusions top out at $500,000 for: married couples who file joint returns; and qualifying widows/widowers, the IRS term for surviving spouses who qualify for the same breaks as married couple for two years after a spouse’s death. They drop to $250,000 for returns submitted by: single persons; heads of household (mostly unmarried individuals with children); and married couples who file separately. 

When do sellers have to reckon with taxes? Only when their profits surpass the $500,00/$250,000 ceilings.

Key requirements. To illustrate how the current rules work, let’s apply them to sellers Harold and Marian Hill. The couple avail themselves of profit exclusions as long as they comply with two requirements. 

First: they’ve owned and used their dwelling as a principal residence for at least two years out of the five-year period that ends on the sale date. Second: they’ve not excluded gain on the sale of another principal residence within the two years that precede the sale date.

Principal residence. The term, cautions the IRS, means the place the Hills live most of the year, as opposed to a vacation dwelling or property for which they charge rent. More on principal residence later.

The exclusion rules replaced postpone-and-replace rules. The old rules allowed sellers to defer capital gains taxes on all of their past profits, provided they met a pair of requirements. It mattered not how sizable the profits were.

The key stipulation: Harold and Marian had to trade up, meaning purchase a replacement residence that cost more than the amount received for the one they sold. Time limit for the replacement: make the purchase within a period spanning the two years before or two years after the sale.

The old Section 121 carved out an exception for sellers who had attained age 55. They could permanently exclude up to $125,000 of gain without buying another dwelling.

Sidestepping the current limitations on profit exemptions. Predictably, the caps on profit exemptions prompted the Hills and other home owners to search for ways to circumvent the restrictions. Here’s an example of how they prevailed.

Let’s say that the Hills have two homes. One is a house in the city that they live in throughout the year. The other one is a beach condo that they use only for short vacations and occasional weekends. Their main home? The house, not the condo.

The revised rules for Section 121 (since discarded and replaced by stricter ones; more on that in a moment) allow the couple to: move into the condo and convert it into a principal residence; have up to three more years to sell the old principal residence in the city; and still take advantage of the full exclusion. 

What are Harold and Marian able to do after they live for at least two years in the vacation retreat that has become their new principal residence? Unload it and avail themselves of another full exclusion. 

Will a compliant IRS agree that Code Section 121, as then worded, allows that kind of maneuver, notwithstanding that most of the gain on the second place at the beach accumulated while the couple lived in the first one in the city? Yup.

Curbing tax breaks for sellers who unload places that are second homes. Another predictable event: Tax professionals wrote self-congratulatory articles and regaled reporters with accounts of how their adroit counseling helped the Hills and other sellers outsmart the IRS. 

Capitol Hill staffers read the articles while they waded through  infuriated letters from constituents. They immediately alerted their bosses about how effortlessly the Hills snookered the IRS. 

How do displeased lawmakers usually respond?  They enact legislation like the Housing Assistance Act of 2008.

The act curtails the availability of a series of full exclusions for individuals with several homes. Because it prospectively took effect at the start of 2009, there are now old rules and new ones. 

The old ones are for 2008 and earlier years. The new ones for 2009 and later years impose limitations on the amount of the exclusion when a second home becomes a principal residence.

They forbid any exclusion for profit attributable to post-2008 periods of “nonqualified use.” Put more plainly, that means those periods during which the Hills didn’t use the former second home as a principal residence. 

What’s ahead. Part two will focus on the highlights of the current rules that are spelled out in Internal Revenue Code Section 121 (b) (5).

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