Many taxpayers bought a second home, such as a vacation home, with the intention of later converting the second home into their principal residence. Under pre-2008 Housing Act law, those taxpayers could have excluded up to $250,000 ($500,000 for certain joint filers) upon a later sale of that former vacation home as long as the ownership and use tests for the exclusion were satisfied. However, the Housing Act changed the method for recognizing post-2008 gain on the sale of a principal residence formerly used as a vacation or second home.
Specifically, the revised rule makes a portion of the gain from selling the residence—the non-qualified use period—ineligible for the gain exclusion privilege. A property’s nonqualified use period equals the amount of time after 2008 during which the property is not used as the taxpayer’s principal residence. However, periods of nonqualified use don’t include temporary absences that aggregate to two years or less due to the changes of employment, health conditions, or certain other unforeseen circumstances; certain time periods after use as a principal residence; or certain time periods while on qualified official extended duty.
Example 1: Nonqualified use leads to additional taxes.
Floyd bought a vacation home in an exclusive area on January 1, 2005. On January 1, 2011, he converts the property into his principal residence, and he and his wife live there for all of 2011 and 2012. On January 1, 2013, he sells the home for a $450,000 gain. Floyd’s total ownership period is eight years (2005-2012). However, the two years of post-2008 use as a vacation home (2009-2010) count against him and result in a nonexcludable gain of $112,500 (2/8 x $450,000). Floyd must report the $112,500 as capital gain income on his 2013 federal tax return and pay the resulting income tax. If Floyd files jointly, he won’t owe any federal income tax on the remaining $337,500 of gain ($450,000 – $112,500) because it’s completely sheltered by the $500,000 exclusion.
Example 2: Nonqualified use has no impact.
Sandy, a single person, bought a vacation home on January 1, 2001. On January 1, 2011, she converts the property into her principal residence and lives there for all of 2011 and 2012. On January 1, 2013, she sells the home for a $360,000 gain. Sandy’s total ownership period is 12 years (2001-2012), but the two years of post-2008 use as a vacation home (2009-2010) result in a nonexcludable gain of $60,000 (2/12 x $360,000). Sandy can claim the $250,000 home sale gain exclusion against the remaining $300,000 ($360,000 – $60,000) gain, leaving a $50,000 taxable gain. The end result is that Sandy must report a total gain of $110,000 (the nonexcludable gain of $60,000, plus the $50,000 gain in excess of the home sale gain exclusion).
Even before the new nonexcludable gain rule, Sandy would have had to report taxable gain of $110,000 ($360,000-$250,000). Since the $110,000 gain that she would have had to report anyway exceeds the $60,000 nonexcludable gain, the new nonexcludable gain rule has no impact on Sandy.
To minimize the amount of taxable gain from the sale of one of these homes, it is essential that taxpayers keep accurate records of all the money invested in home improvements (before and after it became the taxpayer’s principal residence.)