The IRS No Longer Likes Our Vacation Home

The Capital Gains Exemption for Second Homes is Fading Away 

Mr. and Mrs. ToughMoneyLove bought themselves a 25th anniversary present six years ago: a lake house about 90 minutes away.  We have enjoyed it immensely on weekends and holidays and for week-long gatherings of our extended family.  As a long term plan, we are contemplating using it as a part-time residence in retirement.  That is why we have identified maintaining it as one of our financial goals.

Federal tax policy has generally encouraged the purchase of second homes by allowing tax free capital gains from the eventual sales of such homes, up to a limit of $500,000 for married joint filers.  Thus, if my wife and I were to sell our principal residence and then occupy our vacation home as a principal residence for two years, we could sell it and receive the same exclusion from gross income on any gains from that sale as well. 

Well thanks to the new Housing and Economic Recovery Act of 2008 (all 700 pages of it), this tax benefit is fading away.  Here is the hard truth:  Effective January 1, 2009, the IRS will use the ratio of principal residence years to vacation home years to determine how much of the gain will be excluded from gross income.  Fortunately, they will not count vacation home years prior to 2009.  For example, if we were to adopt our present vacation home (purchased in 2003) as our principal residence at the end of this year, then sell two years later, all of our capital gains (up to the $500,000 limit) will be excluded.  If we keep it as a vacation home, starting in 2009, each of those “vacation home years” will reduce the percentage of eventual gain that we can exclude if we sell. 

The New Rules also Apply to Rental Properties 

No doubt many of you are unsympathetic to this change in the law because you don’t own a second home.  You’re probably thinking “stop your whining and count your blessings Mr. ToughMoneyLove.”  Hey, I would feel the same way in your shoes and yes, we do feel blessed.  On the other hand, perhaps you own a second home, not as a vacation home but as a rental property.  (Or maybe you aspire to do that.)  If so, this change applies to you as well.  This could substantially alter your entire return on investment analysis.  Think about it  – then call your tax advisor.

The Change in Law Could Create Bargain Second Home Opportunities 

Once long-time owners of second homes catch on to this change, it could create opportunities for new owners to purchase these homes.  If existing owners determine that it no longer makes economic sense to own a second home (because they will be losing the capital gains exemption) a lot more of these properties could go on the market, depressing prices.  Homes in suburban areas are particularly vulnerable to further price drops because there are already are signs that falling home values in suburbia could be permanent.  Be alert.

As for us, we are considering keeping our vacation home for the long term and passing it along to our kids.  Let them deal with the tax problems, not us!

There is a lot more stuff buried in this new 700 page law than has been adequately reported in the press.   I’m curious – have any readers uncovered any more hidden gems like this one?

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4 Responses to “The IRS No Longer Likes Our Vacation Home”
  1. I’ve owned a few rentals in my day, and looking to get back into the market lately. I like the “3 chess moves ahead” advice you gave here and will consider it.

    I wrote a post a couple days ago about buying rentals in a college town, but for a select crowd of students (med students, law students, etc.). I was thinking around UNC-Chapel Hill or Va Tech since they’re close by. Got any advice here?

  2. I think owning rental property in a college town is a very good strategy for the reason that the demand is stable. On the other hand, its not exactly an undiscovered market so it would be hard to find a bargain except for something that needs a lot of rehab. Chapel Hill is particularly expensive because it is such a poptular place to live even for non-students. I would also be concerned about being an absentee landlord for a college rental. You would have to hire a management company which really squeezes your margins.

  3. mbhunter says:

    The IRS likes your vacation home just fine. If you didn’t own it, they couldn’t tax you on it. 😉

  4. mbhunter – Well the IRS is not showing me the love like before so to be accurate, they like my money more than my vacation home. Thanks for visiting.

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