An End to the Beach House Loophole?

By Elizabeth Razzi
Sunday, October 21, 2007

Investing in a vacation home would become a little less profitable under a tax change that may become law soon.

The immediate effect will be small, but the action serves as an important reminder for homeowners: Tax breaks can be taken away.

The change is part of a bill passed by the House of Representatives earlier this month that would end the government's kick-'em-when-they're-down treatment of people who lose their homes to foreclosure. Under current law, the federal government taxes people on the unpaid debt as if it were a cash gift bestowed by their lender.

The legislation also would make permanent the tax deduction for private mortgage insurance, which most homeowners have to pay if they made less than a 20 percent down payment.

Both pro-consumer measures draw cheers from practically all corners. But they would cut the government's tax intake, and so to pay for them, the House voted to close a loophole (and that's the word everyone uses for it) that has allowed some vacation-home owners to sell their beach house without paying capital gains tax.

Under current law, married homeowners can pocket as much as $500,000 in capital gains from the sale of their principal residence without paying tax. (Taxpayers filing as singles can claim up to $250,000.) To qualify, you must live in and own the home at least two out of the five years before the sale.

The tax break is not supposed to apply to a vacation home; any profit from that is supposed to be taxed as a capital gain, at a top rate of 15 percent. (That's slated to increase to 20 percent as of 2011.) Enter the loophole: Some tax-savvy owners figured out how to make it apply to the vacation home, too. They would sell their principal residence and take that gain tax-free. Then they would move into their vacation home and make it their principal residence for at least two years. Now they could sell that home, again with a tax-free gain.

The government wants its share, starting with homes sold after Jan. 1, 2008.

The version of the tax legislation working its way through the Senate does not include the vacation-home provisions, but because the major housing lobbying groups do not oppose closing the loophole, it would be a shock to see the Senate turn down the revenue.

So, what exactly would this mean to you and your house in Rehoboth Beach? In the short term, practically nothing. As time passes, however, the phasing-in of the new rules would cause some owners' tax bills to rise significantly.

Here's how it would work, according to Linda Goold, tax counsel for the National Association of Realtors.

For homes sold after Jan. 1, sellers would have to calculate a fraction. The top number would be the number of years the home was your principal residence. The bottom number would be the number of years, starting Jan. 1, that you owned the home. That fraction would determine the share of that $500,000/$250,000 tax break you can claim.

Say, for example, you bought a mountain cabin 10 years ago and have used it only for vacations. Next spring, you make it your principal residence and sell it two years later. Your fraction would be 2/2, (two years as principal residence/two years ownership after January 2008). You would get the full tax break. All that time you owned it before 2008 wouldn't come under the new rules.

But let's say you buy the mountain cabin next month. For five years, 2008 through 2011, you use it only for vacations. After five years of vacationing, you move into the cabin full-time and sell two years later.

Let's be nostalgic and imagine the cabin's value increases sharply, so you actually have a capital gain to worry about. Your fraction would be 2/5, (two years as principal residence/five years ownership after January 2008). You would be able to claim only 40 percent of the tax break, or a maximum of $200,000 in capital gain tax-free if you're married, $100,000 if you're single.

Bette Gallo, president of Prudential Gallo Realtors in Rehoboth and Lewes, said she doesn't think the tax change would affect her market very much. "I guess the government is trying to close up all the loopholes," she said.

Congress's Joint Committee on Taxation estimates the change would bring in $16 million in just its first year -- not a lot of money by federal budget standards, but that's because it applies to just 12 months of gains. As more gain becomes taxable, that number would jump to $121 million by 2010 and continue growing by 16 to 22 percent annually, as those fractions described above grow smaller.

You can limit your exposure to capital gains tax by keeping good records (and receipts) for all the money you spend on home improvements made to your principal residence as well as to a vacation home. If the tax laws change, or if your gain exceeds the exclusion, you could need them to whittle down any tax bill you might owe for capital gains.

Money you invest in the house over the years for durable improvements, including major kitchen appliances, new heating or cooling units, room additions, a new roof or water heater, insulation, or a patio or sidewalk, can significantly trim the amount of capital gain that could be taxable when you sell. Money spent on repairs, such as repainting the house or repairing gutters, doesn't count, because the IRS says they don't add value to the house.

If you decide to upgrade to a better vacation home, tallying those receipts will be the only way to keep the tax bill down.

E-mail Elizabeth Razzi atrazzie@washpost.com.