Taxes, Taxes, Taxes--What the New Housing Bill Means

Until the new housing bill came along, couples selling their first homes weren't taxed on the initial $500,000 (singles escaped taxation on $250,000) of their profit as long as the property was their primary residence for at least two of the five years before the sale. 

A lot of people took advantage of this by selling their first home and moving into an investment or vacation house for two years and then repeating the process. In places where the housing bubble sent home values through the roof, savvy sellers pocketed the first half a million of their profit completely tax-free. 

Tax reformers spotted the loophole and have designed the new housing bill to tighten taxes, with the intention of bringing in over 1.4 billion dollars in tax revenue throughout the coming years. 

Here are the new rules, as outlined by Kenneth Harney of the Washington Post in an article (I found it in The San Jose Mercury News) called Exclusion on sale of 2nd Homes Reduced--

"If you buy a second home or investment property on or after Jan. 1, convert it later into your principle residence and then sell, you'll need to allocate any gain from the sale between periods of qualified and non-qualified usage.

The minimum period for qualified principal residence use will remain as under the current law-- two years out of the five preceding the sale.

Sellers in future years will need to create a fraction against which to multiply their total gain. The numerator will be the time period the house was used as something other than a principal residence. The denominator will be the total period of ownership."

Harney gives a good example that'll be clearer than anything I can sum up--

"Say you're a single taxpayer and you buy a house Jan 1st for $400,000. You rent it out for two years and write off $20,000 in depreciation deductions. Then on Jan. 1 2011 you decide to convert the rental house into your principal residence. You live there for two years. On Jan 1 2013 you move out and put the place up for sale. On Jan 1 2014 you complete the sale of the house for $700,000. 

As under current law, the $20,000 of depreciation write-offs is treated as gross income. The two years of use as a principal residence qualifies you for some amount of tax-free exclusion on the $300,000. But how much?

To figure it out, you dived your aggregate period of non-qualifed use (the two rental years) by your total period of ownership (five years) and multiply that fraction ( 2/4 or 40%) against your total gain of $300,000. The resulting number is the amount that's subject to capital gains taxation--$120,000 in this case. But the remaining $180,000 is tax free."