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Move fast to convert vacation home before tax crackdown

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in Small Business Tax

The new proposed mortgage relief law picking up steam in Congress could close a tax loophole for affluent homeowners. But you can sidestep the expected crackdown if you act fast.

Strategy: Convert a second home you own into your main home as soon as possible. Reason: Under the proposed legislation, you might miss out on a tax-free bonanza for the post-2007 sale of a converted home. Currently, you can claim the full home-sale exclusion when you sell a second home that you’ve converted.

The proposed law will only affect the tax exclusion if you’ve used the home as a vacation home or an investment property after 2007. So you still have time to get in under the wire.

Here’s the whole story: If you own and use your home as your principal residence for at least two of the five years prior to a sale, you can exclude up to $250,000 gain from capital gains tax. The exclusion doubles to $500,000 for joint filers.

Even better, the IRS imposes no current limit on the number of times you can claim the $250,000/$500,000 home-sale exclusion. (Initially, this tax break was a one-time opportunity.) You just need to meet the two-out-of-five-year requirement. Theoretically, you can cash in multiple times during your lifetime.

If you own a second home—such as a vacation home near the water or in the woods—you may first sell your main home at a tax-free profit. Then you can establish the second home as your principal residence. Once you qualify after two years, you could sell the “second home” and claim the home-sale exclusion again.

Example: Say you sold your principal residence for $750,000 in 2004. Its adjusted basis was $300,000, so you excluded $450,000 from tax. In 2005, you moved full time into your “winter place” at a warm-weather site. The winter home has a basis of $250,000 and currently is worth $600,000. If you sell it now, you will receive $350,000 tax-free because you have lived in the home as your principal residence for more than two of the five years preceding the sale.

With the two home sales, you will have collected $800,000 in home-sale profit without paying any federal income tax.

Dark cloud:  The proposed law won’t allow you to claim the full exclusion if you sell a second home after converting it into your principal residence after 2007. Instead, you will lose a portion of your gain exclusion based on how long you used the property as a vacation home or rental property before the sale. The remainder of the gain exclusion will be available as long as you still meet the two-out-of-five year rule (see below).

The proposed law applies to sales made after 2007. But any period of vacation home use or rental use occurring before Jan. 1, 2008, won’t count against you. So the sooner you can move your digs, the better.

Tip: Keep records that can establish when you’ve changed your principal residence.

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