Warning: Tax Loophole for Second Homes Closing

Claiming your vacation home or rental property as your principal residence before you sell won't be the tax saver it once was.

By Joan Pryde, Senior Tax Editor, the Kiplinger letters

October 12, 2007

Folks who move into their second homes and later sell won't get as big a tax break as they may be expecting, thanks to legislation that Congress will pass this fall. A provision in a pending mortgage relief bill blocks homeowners from excluding all of their gain on a second home, even if the home is sold more than two years after it becomes their primary residence.

Here's how the change will work: Currently, you can sell your primary residence and exclude up to $500,000 of gain ($250,000 for singles) if you lived there for two out of the past five years. Then you can move into your second home -- either a vacation property or a home that you've been renting out -- and, if you make it your main home for two years, use the $500,000 exclusion again when you sell it. A House-passed bill would change this by taxing some of the profit on that second home. The amount taxed would be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five-year usage and ownership tests are met.

The good news: There is some transitional relief. The tightening will apply only to sales after 2007. Plus any periods of personal or rental use before 2008 are ignored for purposes of the provision.

For example, say a couple buys a second home in 2006 to use as their vacation home. Three years later, in 2009, they sell their primary residence and move into the vacation home, making it their main home. They sell that home in 2011, realizing a gain of $200,000. Under the proposal, 20% of the gain, or $40,000 (one year of nonqualified use after 2007 divided by five years of ownership), isn't eligible for the capital gains exclusion. The other $160,000 can be excluded from income because the two-year usage and ownership tests were met.

The mortgage relief bill containing this loophole closer is designed to help homeowners caught by the downturn in the subprime mortgage market: Under current law, if your lender forgives a portion of unpaid mortgage debt, you must pay income tax on the forgiven amount to the extent that it exceeds the value of your home, except to the extent you are insolvent. The pending bill would let homeowners exclude those amounts from income. The measure also extends through 2014 the tax deduction for private mortgage insurance, which is scheduled to expire at the end of this year. The loophole closer was added to offset revenue losses from the relief provisions. Because the real estate industry doesn't oppose this tax change, it's a sure bet to pass the Senate and be enacted before Congress adjourns for the year.

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