Contributed by:
Tracie Southerland
Opes Advisors
T: (650) 319-1603
Cell: (650) 255-1477
Email: tsoutherland@opesadvisors.com
If part of your retirement or wealth building strategy included moving into your vacation home or rental property, chances are you will have to pay Uncle Sam more money than you were planning. Thanks to legislation that Congress will pass this fall, the new law is targeted at giving tax relief to people adversely affected by the mortgage & housing meltdown. The House-passed bill prohibits homeowners from excluding all of their gain on a second home, even if the home is sold more than two years after they declare the property as their primary residence.
The mortgage relief bill that contains the new rules about your second home is primarily designed to help out homeowners caught by the downturn in the subprime mortgage market. Since the mortgage relief part of the legislation will reduce tax revenue for the government, Congress needs to make up for the loss of income – the proverbial robbing Peter to pay Paul move.
Under the current law, if your lender forgives a portion of unpaid mortgage debt on your primary residence, you have to pay income tax on the forgiven amount to the extent that it exceeds the value of your home. The mortgage relief bill will let homeowners exclude that amount from taxation. The same bill will extend the current tax deduction for private mortgage insurance (aka PMI) through 2014, which is scheduled to expire at the end of 2007. So you can see why it may be important to make up for the reduction in taxes; it’s just going to be on the backs of those who are likely to be real estate rich.
For your second home or investment property, here is how the old and new tax laws 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. If you then moved into your second property – either a vacation home or a residential property that you’ve been renting out – and, if you make it your main home for two years, you can then use the $500,000 exclusion again when you sell it. Going forward, the bill will change this by taxing more of the profit on that second home. The amount of the tax will be triggered by the length of time the taxpayer owned the property and that it was used as a vacation home or rented out. The balance of the gain will remain eligible for the up-to-$500,000 exclusion. But you must still make sure that you have met the two-out-of-five-year usage and ownership test.
The good news is the implementation of the new law makes the transition somewhat bearable. The bill will only apply to sales after 2007 and any second home usage or rental prior to 2008 are excluded from the calculation. For example, say a married couple bought a vacation home in 2004. Five years later, in 2009, they sell their primary residence and move into their vacation home, making it their main home. They then sell the new main home in 2011, realizing a gain of $500,000. Under the proposal, 20% of the gain, or $100,000 (one year of nonqualified use after 2007 divided by five years of ownership), isn’t eligible for the capital gains exclusion. The other $400,000 can be excluded from taxation because they met the two-year usage and ownership tests. Bottom line – this couple would pay about $25,000 more in Federal and California state taxes than under the old law.
Will this have an impact on second homes or investment property sales? I discussed this with Mark Duvall, Chief Investment Officer at Opes Advisors, Inc., Palo Alto, and Chartered Financial Analyst. He doesn’t see tax issues as being the primary driver behind the decisions people make for buying and selling second homes. “On the margin, such a tax change will lower demand somewhat, thereby moderating price increases,” said Duvall. “I don’t see it as more than a 10% impact on prices, if that.”
It appears that the real estate industry is not opposing this tax change. Therefore it’s sure to pass the Senate and become law before Congress adjourns for the year. Talk with your CPA and Financial & Mortgage Advisor. It’s a lot of money. Be wise.
Copyright © Jeffrey T. Smith.
Jeffrey T. Smith is a Financial Advisor with Opes Advisors
