The Housing and Economic Recovery Act of 2008 became law with a lot of positives for the American People. It took effect on January 1 2009, and the law provides some of the most radical steps taken to help average American homeowners. Some of the highlights include up to $7,500 in purchase credits for first time home buyers, conforming loan limit increases to $625,000 in high cost areas, expansion of the FHA to save delinquent homeowners and funds earmarked for local government to buy and restore blighted homes and neighborhoods. But the law is like sugar coated poison for some homeowners and this is not covered by the main media stream. Deep in the 694 page law, on page 690, there is an important change to the capital gains exclusion rule.
According to basic IRS definitions, capital gains tax is a tax placed on the profits from the sale of real estate or investments. Now under the capital gains exclusion rule, homeowners can claim up to $250,000 or $500,000, if filed jointly, tax-free provided that they have lived there for at least two years of the previous five years. However, the new rule radically changes this exclusion with a new set of formula. Before panic sets in, this law does not apply to homeowners who have lived in their primary residence and have not rented it out. The loss of the $250,000/$500,000 capital gains exclusion applies to properties that have been used as both a primary home and as a rental property only.
In order to make tax-free profits, homeowners used to switch their residence between their homes every two years to gain the capital gains exclusion. Such behavior is useless now as homeowners are now faced with a certain formula when selling their homes.
The capital gains exclusion is now calculated by the profit from the sale of a home times the number of days the home was a primary residence divided by the number of days the home was owned.
So, capital exclusion = Profit x primary days/days the home was owned. Thus is a homeowner lived in the house for two years and the house was rented for the next three years, then when he or she sells the house only 40 percent of the profits are considered tax-free while the rest is taxed under the capital gains tax. Before this new law came into effect, the homeowner got 100 percent of his or her sale with tax-free profit.
So what is the big deal? Well now American homeowners can no longer expect to get the money they are selling their homes for. Currently, the capital gains tax is at 15 percent, so whatever profits are earned that is not covered under the exclusion rule is now taxable. So in effect, homeowners are loosing 15 percent of their profit from the sale of their home to taxes. But 15 percent is not so bad for now, but if the capital gains tax is to change, then homeowners are in real trouble. In the past, it was well known for the capital tax to be even as high as 45 percent. Such a figure can be devastating to homeowners in an already troubled real estate market. This puts more burdens on the average homeowner while the more financially capable individuals make more profit from this bill’s hidden clause.