With The New Housing Law, The $250,000/$500,000 Capital Gains Exclusion is Gone

The Housing and Economic Recovery Act of 2008 passed into law this week with a lot of positives for the American people.

Some of the law's highlights include:

- Up to $7,500 in purchase "credits" for first-time homebuyers
- Conforming loan limit increases to $625,000 in high-cost areas
- Expansion of the FHA to "save" delinquent homeowners
- Earmarked funds for local governments to buy and restore blighted homes and neighborhoods

[Note that the so called “credit” of $7,500 has to be paid back at $500/year for 15 years from your taxes and in a lump sum if you sell before the 15 years are up....it's more like an interest-free loan]

But the new housing law isn't all good news for Americans.  Buried deep on page 690 of the 694-page law, for example, is an important change to the Capital Gains Exclusion rule that could cost home sellers across the country a pretty penny.

Not surprisingly, the story isn't getting much coverage.

Under the former Capital Gains Exclusion rule, home sellers could claim $250,000 of home sale profits tax-free ($500,000 if filing jointly) provided they physically lived in the home for 2 of the previous 5 years.  Savvy real estate investors exploited this tax rule by moving between residences every two years.

Even "regular" homeowners were coached to stay in their homes for at least 2 years for tax reasons.

Under the new Capital Gains Exclusion rule, however, this sort of tax-minimizing behavior is rendered impractical.  The new Capital Gains Exclusion formula is not an all-or-nothing proposition.  Instead, it's a ratio.

The new formula for Capital Gains Exclusion accounts for a home's actual usage as a primary residence over its qualified life:

In other words, if a home seller occupied a property as a primary residence in 2 of the last 5 years, under the new system, he would be entitled to 40% of his capital gains tax-free versus 100 percent of those gains before the new housing law passed.

The effective date for the new Capital Gains Exclusion rules is January 1, 2009 so homeowners selling in 2008 are exempt.  This should lead to flurry of housing activity prior to the New Year because home sellers will want to capture as much of their real estate gains as possible tax-free.

It would appear if the Sellers of a former ‘primary residence’ have less than a $250,000 gain, then they would be better selling by the end of 2008. If they have more than a $250,000 gain, it seems better to wait until 2009. Are you thinking about selling? Have a question? Contact Island Trust Properties and your accountant today!

Sample Equation

You bought a home in January 15 2004 and paid $500,000. This has been your primary residence until this year, January 15 2008, when you bought another property and moved your primary residence. Say you sell your original property next year, January 15 2009, for $600,000. Your capital gains are $100,000. Here's your capital gains exemption formula:

1460 / 1825 = 0.80 x $100,000 = $80,000 Capital Gains Exclusion

Which means you would pay capital gains tax on $20,000. Capital Gains Tax is currently at 15%, so you would pay $3,000 in new taxes that you would have avoided prior to this new law.

**Please note this does not account for the state portion of capital gains; in Hawaii that would currently be an additional 8.25% of the gains or $1,650 for a total of $4,650 in taxes on the gain.
It may sound like a small number when you profit $100,000 to only pay $4,650, but what happens if the new government leaders change the Capital Gains Rate? This rate has been as high as 45.5% in the past. This is not good for future sellers of real estate.

Questions/Concerns

- How will the IRS determine a finite ‘primary residence’ date? We will need an actual date to calculate capital gains. Current rules are very vague and do not call for exact dates of ‘primary residence’ declaration. 

- Who benefits most? The Sellers of high-end luxury properties because they can now claim exemptions they previously were not qualified for (over $250,000 gain is much more likely in Million Dollar-plus price points) or the long-term property owner who sells his farm for millions of dollars that he only paid hundreds for?

- Who is penalized the most? The average homeowner who buys a new home prior to selling their existing. What if she has to rent it out for a year or tow ride out the market and then sell it? Now she’s paying capital gains that she never would have considered under the old rule.

Please note that Island Trust Properties is a real estate brokerage, and not a qualified accountant.  If you think the new Capital Gains Exclusion rules will impact you personally, get professional advice about it.