By Susana Field

You can almost tell how old someone is, or how recently they’ve sold their primary residence, by their working knowledge of the Capital Gains Laws.

[To put you "in the know," in this blog post I'm going to share with you a bit of history and the latest tax-law twist; the closing of a loophole, so to speak, but one which could come with a bite for some of our second home owners.]

My dad is in his eighties and although still an active real estate investor, hasn’t changed his primary residence recently. Thus he was arguing, when I recently had my home for sale, that I’d have to use the profits from the sale of my home to buy another, more expensive, house within the next two years, if I didn’t want to pay capital gains tax on the profit. Or that I could wait until I turned 55 to sell my home, at which time I could take a one-time tax-free gain of up to $125,000.

This is a test: How many of you still believe this too?

Well in 1997 the Tax Payer Relief Act changed the law from how my dad (and maybe you) had known it. Starting in May of that year, if you’d lived in your home two out of the previous five years from the date of sale(regardless of whether you’d owned the house 15 yrs, 7 yrs, 4 yrs, or 2), you could exclude up to $250,000 if single, and $500,000 if married filing jointly, of your profit, from your taxable income. Not bad making, say, $300,000 in tax-free money, huh?

I, being an avid fan of making money in real estate, sold two primary homes in Steamboat Springs over the past three years, pocketed the profits from each, and didn’t pay a cent in Capital Gains Tax. (My dad demanded that I send him – snail-mail- a hard copy of the law.) Test: How many of you have done this too?

My husband, son and I happened to have lived in our two homes for all the years we owned them (seven years in one and three in the other). But, according to the Tax Relief Act of 1997, we didn’t have to have lived in them the whole time to keep 100% of the profit. Remember, the law said we only had to have lived in them for two of the previous five years, meaning we could have bought them as a second home or a rental investment property, and only moved in the last two years before the sale.

Now introduce Section 3092 of Housing Assistance Tax Act of 2008 (H.R. 3221). Test: Have you heard of this one? If so, you must be a tax advisor!

To be able claim 100% of your eligible profit now, it has to start out being your primary residence for two years (the first two years of the five years before the sale,at which point you can rent it if you’d like, for the next three years. But not the other way around. Starting January 1st, 2009, the clock, so to speak, starts ticking.

Example: Let’s say you and your husband bought a great ski-in, ski-out condo here in Steamboat on January 1st, 2009, for $500,000. Since you’re only going to use it four weeks a year, until you move out here,  you put it in a rental pool to make enough income to pay your HOA dues. On January 1st, 2011 you take it off the rental pool and begin using it as your primary home. Your mother gets ill and you move out on January 1st, 2013 to take care of her back east, and sell the condo for $800,000 on January 1st, 2014.

Until this recent change in the law your entire $300,000 profit would have been eligible for capital gains tax exclusion, because you lived in it as your primary residence for two of the previous five calendar years.
 
But with the new law, you have to start out with it being your primary residence for two years before you can rent it to someone, if you want to keep 100% of your tax exclusion. So in the example above, the period 2009-2010 will be considered a non-qualifying period because the condo didn’t start out as your primary residence! The year 2013, after you moved out but before you sold it, is  a qualifying use; you weren’t there and you could have rented it even. So, those first two rental years (2/5 or 40%) are counted as non-qualifying use, and the next three years (3/5 or 60%) are considered qualifying use.
 
Of the $300,000 profit, you will now have to pay taxes on 40% of it ($120,000; the non-qualifying time because you were renting it)! Ouch! You can still exclude from taxes 60% of the profit ($180,000; the qualifying time).

(FYI:The law states that they won’t go prior to January 1st, 2009, for the pro-rationing, so as long as you lived in the house for two out of the past five years you are okay.)

This law is meant to close the loophole which was allowing someone to buy a vacation home, put it in the rental pool or even leave it empty for however many years, move into it for two years, then sell it and not pay a cent on the profit. Now they’ll have to pay taxes on at least some of their profit.

Bottomline:
1. If you’ve been planning all these years on using the loophole to your advantage, you’d better move into that vacation home now, because the clock is ticking and you’ve already lost 6 months!

2. If you want to buy an investment property, consider living in it for the first two years and rent it for the next three.

3. Most importantly: When it comes to real estate, always consult with your tax accountant.

And if you’re thinking of buying real estate in Steamboat Springs, come talk to us!