With The New Housing Law, The $250,000/$500,000 Capital Gains Exclusion Is Gone For Some

• Tweet

The Housing and Economic Recovery Act of 2008 passed into law this week with a lot of positives for the American people.

Some of the law's highlights include:

• Up to $7,500 in purchase "credits" for first-time homebuyers
• Conforming loan limit increases to $625,000 in high-cost areas
• Expansion of the FHA to "save" delinquent homeowners
• Earmarked funds for local governments to buy and restore blighted homes and neighborhoods

But the new housing law isn't all good news for Americans.  Buried deep on page 690 of the 694-page law, for example, is an important change to the Capital Gains Exclusion rule that could cost some home sellers across the country a pretty penny.

Not surprisingly, the story isn't getting much coverage.

Under the former Capital Gains Exclusion rule, any home seller 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.

Under the new Capital Gains Exclusion rule, however, this sort of tax-minimizing behavior is rendered impractical. 

For homeowners converting a second home or investment property into a primary residence, the new formula is no longer an all-or-nothing proposition.  Instead, it's a ratio.  The new Capital Gains Exclusion formula accounts for a home's actual usage as a primary residence over its qualified life:

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.  This should lead to flurry of housing activity prior to the New Year because home sellers will want to capture as much of their real estate gains as possible tax-free.

And remember -- the new rules only apply to homeowners moving into property formerly designated as a second home or investment property.

As always, remember that I am a mortgage guy and not a qualified accountant.  If you think the new Capital Gains Exclusion rules will impact you personally, get professional advice about it.