Sep 04, 2008

Changes to the Principal Residence Exclusion

Most would-be homeowners have heard of one of the primary benefits of purchasing: the tax-free gain you get when you sell. If you own and live in your house for at least two out of the five years before you sell, you do not have to pay taxes on the first $250,000 of gain from the sale ($500,000, if married and filing jointly). Most first-time buyers don't need to hear more -- their first homes are stepping stones; they don't expect to be in their homes long enough to exceed these maximums.

But be careful if your plan is to hold on to your home and rent it out -- not an uncommon strategy for many homeowners today who need to move but aren't ready to sell at the low prices dominating many real estate markets. When it comes to taxes, rental property isn't treated the same as a principal residence. You are taxed on the full gain when you sell, usually at 15% (the current federal capital gains rate for most taxpayers).

To get around this, rental property owners used to be able to convert rental properties to personal residences. If they lived there for two out of the five years before sale, they'd qualify for the principal residence exclusion. The law has changed, however. Now, the time the property is not your principal residence is considered "non-qualified use". You are only permitted to exclude gain for qualified use -- the time the property is your principal residence. So if you own a property for 10 years and only live in it for the last two before selling, you can exclude 20% of your gain and will have to pay taxes on the remaining 80%. (Non-qualified use before 2009 doesn't count, however.)

You don't need to worry about this if you don't ever plan to rent your house out. If you think you might, however, be aware of the tax implications of doing so.

Alayna Schroeder