The new housing rescue bill signed into law by the President last week includes some ugly tax changes especially for vacation home and investment property owners.
The new law changes capital gains treatment of these properties eliminating the some of the prior rules which savvy investors used to avoid these taxes.
Under the old rules one could use the $250,000 ($500,000 for married couples) exemption of tax on home sales if they use the property as their principal residence for 2 out of the last five years.
Here’s how a savvy investor would use the old law to execute a tax free sale of an investment property.
Let’s say I own my home in June of 1995 in Denver and I own 2 nice rentals in Denver as well. All three homes over the next 5 years gain $150,000 in value. As a smart investor I’m watching the market and I estimate the top for the market will be the summer of 2006 and I have decided to dump all properties by that date to retire. I want to do it without being required by a 1031 exchange to reinvest in real estate and , most importantly, I want to give the tax man nothing on the capital gains.
I sell my current primary residence in 2000 pocketing tax free the first $150,000. I move into one of the rentals making it my primary residence and live there for 2 years. I sell the second home and pocket the second $150,000 tax free as well. I then move into the 3rd home and repeat the process.
I started liquidating in 2000 and I’m done sometime between the end of 2004 and the beginning of 2006. This process allows me to bank $450,000 ($150,000 x 3) tax free, pay no capital gains tax, avoid a 1031 exchange, just by planning ahead. I can now retire and buy my retirement home for cash with money Uncle Sam normally would have put his grubby hands on.
If I was married filing a joint return and each house gained the maximum, $500,000, I would pocket $1,500,000 completely tax free!
Sounds beautiful, right?
Well that was then, this is now…
Sadly, this option in now gone due to the new housing rescue law. Under the new law, the capital gains on the second and third home in my scenario are taxed based on the number of days the house was not a qualified personal residence. The gain resulting from appreciation on the property after May 6, 1997 will be taxed as ordinary income.
Folks we just got one of the best tax avoidance tools in our arsenal pulled right out from under our feet.
There’s no other way to put it…this just sucks!