Own a vacation home? Watch for this tax trap

The Housing Assistance Act of 2008, which was passed at the beginning of August, has a not-so-nice provision that will negatively impact owners of vacation homes. The provision applies to the $250,000(singles)/$500,000 (for couples filing jointly) capital gains tax exclusion on personal residences.

Most people are familiar with this exclusion which allows $250,000 or $500,000 in gains to be exempt from taxation if you sell your primary residence. This exclusion could also be applied to gains from the sale of a vacation home if the owners carefully planned where they lived in the years before the sale. In fact, owners of multiple homes could stagger where they lived and capture several of these $250,000/$500,000 exclusions in their lifetime. Now, it will be much harder to capture this favorable tax treatment for vacation homes.

Here is an example. A couple buys a vacation home, but they are both still working so they do not make it their primary residence. They retire in 15 years and move into what was once their vacation home. They live in the vacation home for 15 more years and then sell the property. If they paid $400,000 for the house originally and sold it for $900,000 30 years later, they would have a gain of $500,000. Under the old law, all of this gain would be exempt from taxes. However, under the new law, only 50 percent of the gain would be exempt from taxation because the couple only used the home as a primary residence for half of the total time they owned it. The end result will be a pretty big tax hit.

This new law does not take effect until January 1, 2009 so one option is to consider moving into your vacation home before the end of this year. Consult your advisor or accountant for more information, but remember that these changes apply only to vacation homes that you convert to a primary residence -- no changes are expected to the rules that apply to a home that has always been your primary residence.