You thought you were making such a smart tax move when you made your vacation home your primary residence.
You and your spouse thought downsizing was a good idea and if you eventually sold that home you would be protected from capital gains taxes, as long as those gains didn’t exceed $500,000 (the limit if filing jointly) and you met the residency requirement.
Until Jan. 1, 2009, you would have been right. But the law has changed and you should be aware of the changes and what they might mean to your tax bill before you consider buying and selling.
Previously, the Internal Revenue Service said that if you live in the investment property for 2 years during the 5 years prior to selling the home, you could sell it as your primary residence and exclude $250,000 from the gain of your sale ($500,000 if you’re married filing jointly). If your gains were under that limit, you wouldn’t pay any taxes for long-term capital gains, which apply to assets held for at least 1 year.
A gain occurs when you sell a property for a higher price than what you bought it for plus the costs of any capital improvements you made to the property and the costs of sale.
But if you sell after Jan. 1, 2009, you may not take the full exclusion — commonly called the 121 exclusion for its section number in the tax code — if the home was an investment property before it was your primary residence.
Keep in mind the good news — any time the residence was used as an investment property before Jan. 1, 2009 doesn’t count against you.
In light of the passage of the Housing and Economic Recovery Act of 2008, the IRS now asks home owners at the time of sale to calculate “qualified time” (the time the property was used as your personal residence) and “non-qualified time” (the period property was not your primary residence after Jan. 1, 2009). You will owe capital gains on the non-qualified time.
And the difference under this new law could be costly.
Related reading material:
- Selling Your Home(s): How to Parlay the “Up to” $250,000/$500,000 Capital Gain Exclusion on Each Residence Sale into a Tax-Free Nest Egg
- Capital Gains, Minimal Taxes 2009: The Essential Guide For Investors And Traders
- Protect Your Estate: Definitive Strategies for Estate and Wealth Planning from the Leading Experts
Judith Akin, an enrolled agent and manager of Judith A. Akin, EA, Tax and Financial Services in Oklahoma City, gives this example:
John buys a rental property Jan. 1, 2009, rents it out for 8 years and lives in it as his primary residence for the next 2 years, then sells for a $100,000 gain. He still meets the 2-out-of-5 years residency rule for the 121 exemption but now with the change in law he has to separate the time he used the property as a rental. So he now owes tax on 8/10ths of the gain (for 8 of the 10 years). That translates to $80,000 of gain he will be taxed on. At a 15 percent federal tax rate, that will cost him $12,000. He may also have to pay state capital gains tax. He wouldn’t have had to pay anything in federal capital gains under the previous law, Akin says.
Say you’re eyeing a vacation home that you might be able to get for a bargain in today’s housing market. And say you plan to rent out that residence until you move in for your retirement. Here are some points you should consider:
- Determine how long you plan to rent out the residence before moving in. Akin says the sooner you plan to make it your residence the better. “This is a particular consideration because people buying now are likely going in low so there is a greater likelihood that they will have substantial capital gains when they sell way down the road.” If much of that time the property has been used as a rental, you’re going to get hit with substantial capital gains tax, she says.
- Keep in mind you still have to “recapture” the depreciation costs you’ve taken on the property on your tax forms since 1997. You have to add what you’ve taken in depreciation costs back as income when it comes time to sell and that is taxed at a maximum 25 percent, says Jerry Joyce, an enrolled agent and owner of Alternative Tax Services in Tampa, Fla. Depreciation does not come under the 121 exclusion, he notes.
- Keep good records. Akin says the new law can pose an accounting nightmare. Because the IRS wants to know the rental versus residence breakdown, you will have to have good documentation, she says.
- Consult both a tax expert and a real estate agent about the change in the law. They will help you in different ways with facts and market strategies, says Jon Mann, a real estate broker with Prudential Locations in Honolulu. He says even with the change in the law, buying a place to rent out, then move into, then sell “can still be a positive, equity-improving, value-added situation for buyers and sellers,” though perhaps not quite as attractive as it was prior to Jan. 1, 2009.
Now let’s turn the tables and say your problem is not gain, but loss, when it comes time to sell your primary residence which you previously treated as an investment property. There’s some good news here in the new law, Akin says.
“Under the new law, because you portion out the part that was investment property, you get to deduct some or all of that loss,” she says. Before the change in the law, you could separate rental from residence, you would not have been able to deduct a loss on your personal residence, she says.
Source : http://www.discovercard.com/cardmembersvcs/edge
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