Universal Exclusion for Former Vacation Homes

The Internal Revenue Code provides for an exclusion on the sale of a principal residence for an amount not to exceed $500,000, for which no federal income tax is due. The term "universal exclusion" refers to the $250,000 ($500,000 for married couples filing jointly) of profit that is excluded from federal taxation when a taxpayer sells a principal residence after:

• Owning it for not less than 2 years; and
• Occupying it as a principal residence for not less than 2 out of the 5 years prior to the resale; and
• Providing the taxpayer hasn't claimed the exclusion on the sale of another residence within the 2 years prior to the resale.

(Please note that all 3 requirements must be satisfied. [See worksheet.])

Since many individuals often purchase vacation homes as an investment strategy for retirement, their long-term goal being to sell their current residence and take advantage of the universal exclusion, and then move into the vacation home and claim it as their principal residence. Prior to the enactment of Housing and Economic Recovery Act of 2008 ("HERA"), once they had met the ownership and occupancy requirements, they could resell the vacation home and again take advantage of the universal exclusion. This was a great strategy for converting real estate assets to cash and avoiding federal income taxes in the process. However, since the enactment of HERA, and specifically Section 3092 thereof, there is a new calculation to determine the amount of the universal exclusion that may be claimed for a vacation home that is purchased and later converted to a principal residence.

Specifically, the amount of the exclusion is now limited to the fraction of profit created when dividing the number of years the home was used as a principal residence by the total number of years the property has been owned. Consider the following example:

EXAMPLE: A married couple purchases a vacation home for $300,000. Ten years later, they sell their current principal residence, take advantage of the universal exclusion, and then make the vacation home their principal residence. Fifteen years after that, they resell the vacation home for $800,000. To summarize, this couple has owned the vacation home for 25 years, they've used it as their principal residence for 15 years, and they've realized a profit of $500,000 upon resale.

Prior to HERA, this couple could have excluded the entire $500,000 of profit on this former vacation home. As a result of HERA, they may exclude from federal taxation only 15/25ths, or 60%, of the $500,000 profit. This means that $300,000 of the $500,000 profit is tax free, but the couple must pay capital gains taxes on the remaining $200,000.

This new limitation applies to sales closing on or after January 1, 2009 and only to nonqualified use periods beginning on or after that date. In other words, when such a property is sold in the future, the periods of use as a vacation home or rental property that occurred before January 1, 2009 are treated as if the use was as a principal residence.

This Blog is not intended to be legal or tax advice and readers of this Blog should consult their own lawyer or tax preparer for legal or tax advice, as applicable.