Housing and Economic Recovery Act of 2008

by Brad Nix on 03. Aug, 2008 in First Time Buyers, Real Estate Finance

UPDATE: Linda Dvorak commented at Agent Genius with some great clarifications of the nuances of the capital gains issue in this law.  Please visit http://agentgenius.com/?p=3193#comment-16288 and read comment #41 for a great explanation.  You can also visit Exeter for a detailed analysis.

The Housing and Economic Recovery Act of 2008 was recently passed and it included many positive things for buyers and sellers of real property. Many real estate bloggers have covered this topic (view blog search results), but Dan Green brought to light one of the biggest downsides to the new act.

As he found buried deep on page 690 of the 694 page law an important change to the Capital Gains Exclusion rule that could cost home sellers across the country.  Dan said…

“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.

In other words, if a home seller occupied a property as a primary residence in 2 of the last 5 year, 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. “

Here is the formula:

Here is a sample equation:

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

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

1460(365 days x 4 years) / 1825(365 days x 1 year) = 0.80 x $100,000 ($600,000 – $500,000) = $80,000

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 Georgia that would be an additional 6% of the gains or $1,200 for a total of $4,200 in taxes on the gain.

It may sound like a small number when you profit $100,000 to only pay $4200, but what happens if the new government leaders change the Capital Gains Rate? This rate has been as high as 45.5 percent in the past.  This is not good for future sellers of real estate.

Related posts:

  1. What Everybody Ought to Know About the Housing Bubble.
  2. 4 Reasons To Buy an Atlanta Area Home before October 1st, 2008!
  3. Will you still love me? Will you still tax me? When I’m 62.

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  • Devin
    I don't think your example is exaclty correct. I've been reading the bill and it says the term 'period of nonqualified uses(not primary residence) means any period other than the portion of any period preceding January 1, 2009 during which the property is not used as the principal residence of the taxpayer.

    So lets say they sold the house on January 31 2009 and bought the house on January 1 2004 (all other variable remain the same). The equation would be 1,825 (365 *5)/1856(1825+31 days in 2009 not as primary)=.95*100,000=98,329. Which means you have to pay capital gains $1,671.

    So it's not a look back it just takes into fact the amount of nonqualified use after January 1 2009. It is tax law and reading this crap doesn't make much sense but that is what I got out of it.

    Congress closed another loop hole unfortunatly this hurts the middle class because they were the ones taking the risk and trying to build wealth through the old program.
  • Miller
    I agree that this hurts the middle class.I feel like we should all start writing our congress people.

    My husband & I worked hard (over 30 years) for our home that we lived in for 13 years. Due to a layoff, we had to relocate, but kept our family home so that we could move back in and retire in it, then sell it and take the capital gains to live on in our old age. Now, if we don't move back right away, it will be considered NON-QUALIFIED and every day we delay, we lose future gains. We are forced to stay where the jobs are until we can collect Social Security (Ha Ha!) and what is left of our IRA after the financial crash. Now, they took the our last real hope away from us.

    I still am unclear about the formula. Maybe someone can figure it out for us? Bought the home in 1986, lived in it until 2000, rented until present. Plan to move in again in 16 years. (If we have to, we will split up our family so that at least one of us can claim it as our primary residence)

    Please help us!
  • Here is the best explanation of this issue: http://www.exeterco.com/article_changes_to_section_121.aspx
  • great information. I will use it as evidence that investment property can give tremendous tax benifits
  • dale
    I thought this only applied to those "second homes" that were purchased after Dec. 31, 2008. Let me know.
  • It actually only affects those that held their second homes as investment first, then moved into the property.

    According to Exeter (http://www.exeterco.com/article_changes_to_section_121.aspx):

    "Summary of Changes

    Property Held For Rental or Investment First

    Property held for investment purposes and then subsequently converted into a primary residence will be impacted the most under these legislative changes to Section 121.

    The amount of time that the real property was held as investment property (non-qualified use) will no longer qualify for tax free exclusion under Section 121. Only the actual time that the real property was held and used as a primary residence (qualified use) will qualify for the tax free exclusion.

    This will significantly affect those homeowners who had planned to move into investment property and convert its usage to their primary residence in order to take advantage of the 121 exclusion. The longer the real property was held for investment the greater the impact will be on the amount of capital gain that can be excluded from taxable income (i.e. the more capital gain that must be included in taxable income).

    Property Held As Primary Residence First

    The modifications made to Section 121 do not affect homeowners that move out of their primary residence and convert it to non-qualified use. The homeowner can still take the full amount of the 121 exclusion upon the sale of the property as long as they still qualify for the 121 exclusion.

    In other words, a primary residence that is subsequently converted into investment property will still qualify for the tax free exclusion under Section 121 provided the property is sold no later than three (3) years after its conversion to investment property. The property will no longer qualify for the 121 exclusion once it has been held by the homeowner as investment property beyond the three (3) year window."
  • Linda Dvorak commented at Agent Genius with some great clarifications of the nuances of the capital gains issue in this law. Please visit http://agentgenius.com/?p=3193#comment-16288 and read comment #41 for a great explanation. You can also visit Exeter (http://www.exeterco.com/article_changes_to_section_121.aspx) for a detailed analysis.
  • Dave Rifkin
    While the equation is correct, the sample is NOT. All years prior to Jan. '09 are considered "primary residence" years according to the bill. So, there would be no penalty in moving out on Jan. 2008, and thus you would get the full $100,000. capital gains exclusion upon the sale in Jan 2009.

    DR
  • Dave: I did not read that any time prior to 2009 would be considered 'primary residence' (PR) years. This is a big factor. In essence, those who are close to the 2 in 5 rule should wait until 2009 and get 3 years of free 'PR'? This is a point that needs to be confirmed. Great eye for details!
  • Dave Rifkin
    Thanks Brad,

    Here's the quote from the Bill:

    " IN GENERAL.—The term ‘period of nonqualified use’ means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse."

    So, it seems that they are not going to penalize current rental property owners for the years they have been rented prior to Jan. '09. So, let's say you have owned a rental for 10 years.....if you move in on Jan. 1, '09, and live there for 2-years, you could sell with 100% of the capital gains excluded. Such a deal!

    DR

  • Dave:

    You have just become my favorite commentor! This is great insight. Thank you for bringing it to our community's attention. I'd love to learn more about you and your background also.
  • Devin
    I'm still having issues on your calculation. When I read it it says "gain shall be allocated to periods of nonqualified use based on the ratio which - the aggregate periods of nonqualified use during the period such property was owned by the taxpayer bears to the period of such property was oned by the taxpayer. So your equation should read number of days of nonqualifed use after jan 1 2009/number of days property was owned.

    So if you bought in 1990 100,000 and sold in 2020 for 200k and lived as primary from 2018 to 2010 it would be 3,285(365 *9)/10,950 (365*30)=.30 so you would have to pay capital gains on 30k.
  • Sounds like a tax increase to me. Brad, I am glad you published this excerpt. I have heard very little of this through conventional media sources. Someone notify Clark Howard!

    So, in short, for those of our clients who live in a home 3 to 4 years, they will absolutely have a tax liability upon the sale of their home.
  • Mike: this will only affect Sellers who stop using a 'primary residence' and start using a new 'primary residence' prior to selling their old one. In other words, if you just live the house 100% of the time you own it, then the formula will result in you getting 100% exemption on the gains of the sale, regardless of the amount of gains. The change only affects the amount of the market who owns two properties at a time in which the former property was once a 'primary residence'. I for one am a good example.

    I bought a house last year and declared it my primary residence (PR) in 2007. I tried to sell my former PR but was unhappy with the market and decided to lease it for a year (thru Dec 2008). Now if I wait to sell it in 2009, I will have to calculate the Cap Gains Exemption based on the formula above. Instead of just being exempt up to $250,000 in gain (which I would not come to in the old rule).
  • Justin
    I know several people who took 1031 money and put it into a primary residence to then sell it and never pay tax. This new law may curtail this practice significantly. I hear a lot real estate sellers are having heartburn over Obama's tax plans. It appears he wants to make our country into a socialist society. I certainly hope not.
  • Justin:
    While I share your concerns over Obama's tax plans, I question the legality of your 1031 statement. As always, readers should consult an attorney in these legal matters, but it is my understanding that 1031 money must always be used for investment property and can never be transferred into your primary residence without paying the capital gains on the investment sold. I represent many 1031 clients and have done a few myself, the purpose of the IRS rule is to allow like-kind investments to defer taxes. The IRS considers "like-kind" to be any investment property held for at least one year and a day. They do not include 'primary residence' as an investment property.
  • This is definitely not good for sellers. Here in Florida, I have several clients that cycle through houses every 2 years for this tax exclusion. I sure hope we don't end up with a new president that wants to double the capital gains tax.
  • I wonder what other little surprises will be dug out when this is fully digested?
  • wow brad, great stuff. very important info that I've not heard elsewhere yet. thanks
  • Thanks Matt. It's amazing what they sneak into these laws. I assume this is how they plan to pay for all of the other concessions and bailouts. The biggest question I have now (hopefully a reader knows the answer) is...How does the IRS determine when your 'primary residence' begins at a new house? Is there a specific trigger int he IRS code? Or can owners just decide when to begin 'primary residence' in a new property? The answer to this question is key to determining what you will actually pay on Capital Gains.
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