The Daily 2¢ - Limiting The Loophole

As many of you already know there is a very juicy loophole in the federal tax code that allows for a gargantuan exclusion ($250,000 for a single homeowner, $500,000 for a couple) of the gain from the sale of a principle residence from traditional taxation, so long as the taxpaying homeowner had used the property as a primary residence for an “aggregate” of 2 years of the 5 years prior to the sale.

The “aggregate” language in the tax code is important as it allows for the flexibility of using the property for other purposes (such as a vacation home or a rental property) during the 5 years prior to the sale but still meet the residency requirement as long as the time the property had been used as a primary residence totals 2 years.

To say that this WAS an important tax loophole for lower to middle income as well as affluent homeowners is an understatement as the notion of such a large tax free capital gain likely greatly contributed to the excitement seen in residential real estate since the loophole was passed into law back in 1997.

Yesterday though, the House Ways and Means Committee, chaired by Representative Charles Rangel (D-NY) set the stage for an aggressive change of the tax code that, if passed into law, would greatly limit the flexibility inherent in the existing loophole.

The proposed changes that ironically ride along within the “Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648)” bill that was requested by President Bush in response to the subprime mortgage debacle, appears to eliminate the tax break for any gain associated to the periods where the property is NOT used as a primary residence.

The bill achieves this feat by introducing the notion of a “period of nonqualified use” which is defined as any period that the homeowner or spouse does NOT use the property as a primary residence.

The bill goes on to propose an exception that, while puzzling and poorly designed, appears to grant an exception to all periods of “non qualified use” that occurs AFTER “qualified” period of primary residency within the final 5 year period prior to sale.

By this they may possibly mean that after an initially fully qualified primary use, i.e. 2 years or primary residency, any "nonqualified" use occurring within 5 years prior to sale would be considered "qualified"

So, in general, come the effective date of January 1 2008, all gain from periods where a property is squarely a second home, be it vacation or investment, will be taxed.

It's important to note that the proposed changes are, in effect, being established exclusively to provide tax revenues needed make up the shortfall derived from the bills primary goal of tax relief for homeowners who had a portion of their housing debt forgiven in lieu of foreclosure.

Keep in mind though that the proposed changes have simply been unanimously agreed upon by the House Ways and Means Committee so there is still the House passage, Senate proposed legislation and passage, reconciliation and of course President Bush’s signature standing in the way of these changes becoming law.

On a side note, one of the authors of the current bill threw in a totally unrelated change to the tax law regarding the time of payment for corporate estimated taxes… isn’t it just lovely how the government works?