A long known “loophole” strategy in real estate has been to purchase a vacation home or a rental property and one day convert it to your principal residence.  Then, you could use the home sale exclusion rule to exclude up to $500,000 in gains (for married filing jointly).  Well, if that was your strategy, it might be time to rethink it or analyze it a bit further.  The latest tax bill passed on July 30 will make some changes to this law.

After 2008, some homesellers who don’t use their properties as principal residences for their entire ownership period may wind up paying more of a tax bill than they would under current rules (or pay tax when none would be owed currently). The tax break affected is the homesale exclusion, which generally allows up to $250,000 of homesale profit to be tax-free if a home was owned and used by the seller as a principal residence (i.e., main home) for at least 2 of the 5 years before the sale. In general, the tax-free break can only be used once every 2 years. The tax-free profit amount is up to $500,000 for married taxpayers filing jointly for the year of sale if several conditions are met. Because of the “principal residence” requirement, vacation or second homes normally don’t qualify for the exclusion. However, in what some saw as a loophole, the law permitted taxpayers to convert their second home to their principal residence, live in It for two years, sell it, and take the full $250,000/$500,000 exclusion available for principal residences, even though portions of their gains were attributable to periods when the property was used as a vacation or second home, not a principal residence.

For sales after 2008, the homesale exclusion will be reduced proportionately for the period of time a home wasn’t used as a principal residence. The prime example is a vacation home that is turned into a principal residence by its owners, but the new rule also can hit individuals who use a property as a main home for a while, rent it out for a period of time, and then move back in. There are, however, a number of exceptions. For starters, pre-2009 periods of non-principal-residence use don’t count, and neither do periods of temporary absence totaling no more than 2 years due to health or employment changes (or certain unforeseen circumstances), or up to 10 years of absence for qualifying members of the military or certain government employees. Finally, non-principal-residence use doesn’t count if it occurs (1) in the five years preceding the sale, but (2) after you permanently stop using the home as a main home.

The new law closes that “loophole” by requiring homeowners to pay taxes on gains made from the sale of a second home to reflect the portion of time the home was not used as a principal residence (e.g, vacation or rental property). The amount taxed will be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The new law in effect reduces the exclusion based on the ratio of years of use as a principal residence to the total time of ownership. For example, if a taxpayer owned a vacation home for ten years, but lived in it as a principal residence only for the final two years prior to sale, the maximum available exclusion would be reduced by four-fifths. Accordingly, a $400,000 gain on the sale that would be eligible for the full exclusion under pre-Act law would be reduced by four-fifths, to $80,000.

The good news for current owners of second homes is that the new law is not retroactive. The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of the provision. Also, the new law doesn’t change the rule that allows homeowners to take advantage of the homesale exclusion every two years. Taxpayers can still “home hop” with full tax exclusion if they only own one home at a time. Moreover, the taxpayer still qualifies for capital gain treatment on the amount of gain that cannot be excluded. As you can see, the new rule is quite complex and down the road will cause big headaches for some homesellers unless they’re careful and get an expert’s advice.   Call us if you would like to sort out your situation and see what effect this law change will have for you.

The Tax Foundation released a study the detailed New Census Data on Property Taxes on Homeowners. An interesting fact that came out of the study was that blue states (those that voted for John Kerry in 2004) paid a higher rate of property taxes than those in red states (those that voted for George W. Bush in 2004).

The results are interesting, but I would like to see a more complete picture. Some of the states do not have income taxes, some have high tourism taxes, the gas taxes all very by state. I would like to see a breakdown of total tax obligations split among the states. Odds are the result would be remarkably similar.

Median Real Estates Tax

Many folks are re-evaluating their financial positions and some are second guessing their investing over the past three to five years.  When times are good in our economy, some take risks that they might not take in market that is not as favorable.  I have heard recent talk of people wanting to let properties go to foreclosure.  Remember that foreclosure is kind of like bankruptcy – it should be your last option.  Foreclosure will also live to haunt you for a long time after the initial sting is gone.

Foreclosure has tax consequences that most overlook and may bring back that pain a year later.  I was recently speaking with one of my clients who works with a lot of real estate investors.   He asked me some valuable questions with hard answers that I think a lot more people should hear to understand the long term effects of foreclosure.  Let’s look at an example:

• Property purchased in 2005 for $700,000
• He put 10% cash down and has an interest only mortgage; so mortgage balance is currently  $630,000
• Bank forecloses and sells for $400,000
• The bank either holds the owner liable for the remaining $230,000 ($630,000 mortgage less $400,000 received in sale – note there are probably other bank fees to add to the recoverable amount from the bank, but we have dismissed these for this example)
  • OR bank cancels the remaining debt of $230,000 if it believes it is uncollectible 
• The owner receives a cancellation of debt 1099 for $230,000 that is TAXABLE.  This generates a balance due of approximately $85,000 (depending on tax rates for federal and state).

Now, let’s look at the alternatives.  Chances are very good that the bank will sell the property for less than you can even at a “fire sale” price.  Try your hardest to dump the property through a sale before it goes to foreclosure.  This will also help salvage your future credit report – the foreclosure would stay on your report for the next seven years.

Also, if you will need to come up with $85,000 to pay the IRS that you will never see again – it would have only cost you $44,100 (assuming 7% interest) in payments to hold the property for another year and attempt to wait out the market or find a buyer.

There is a lot of talk on the news about how bad the real estate market is right now. It is actually only bad if you want to sell. The market is fantastic right now if you are looking to buy or invest. There are many reasons for this, but two that stand out as obvious.

Firstly, the market over reacts. This happens many times that their is a big drop in anything. Think about when a stock crashes. It is flying high at $100 a share or so – then drops like a rock – all the way to $20. Within a few weeks, it is back to $30 – $35. Why? Because the market overreacted. People panicked and sold at $25 and $30 when they should have just held. Once the market stabilized it went back to where it should have stopped falling to begin with.

A similar thing has occurred in our current real estate market. Housing prices started to drop and people panicked. Many cut their prices further than they should have. Many investors panicked and stopped investing for fear of losing. Thus, less buyers. With less potential buyers, even lower prices were sometimes required to sell properties. The media has not helped things with its love affair with bad news. They always place the most negative spin possible on each and every story.

The second big reason the real estate market will come back is inflation. New construction is more expensive to produce now than it has ever been. This has hurt the housing market temporarily because smaller builders have not been able to afford to ride the wave. In the long term, prices will have to move in line with the cost to produce a new house or building.

We recently decided to move our offices into a new building up the road from our current location. The per square foot predevelopment cost to build that building from the ground up were approximately 250% of the cost of our existing office when we purchased it just before the real estate bust 1 1/2 years ago.

The bottom line is that builders will not build if they are losing money. The extra cost of fuel and construction materials must be factored into the cost of housing. Right now, it is not. As current inventory is slowly absorbed, prices will rise again.

Who will win? The people that will win in this real estate market are not the people selling at all cost or the people that are sitting on the sidelines whining. The people that will win are the people who are out there strategically investing into the market. The current rental rates are as high as ever (at least in my market). The individuals that get in the game will be the winner. No one has ever won by sitting on the sidelines complaining.