Owners of Second Homes: Beware of New Tax Laws

The following is a guest post from Marotta Asset Management.

If you own two homes, sell the one you are living in and move into your second home as soon as possible. Tax changes taking effect on January 1 will make owning a second home much less attractive in 2009. As a result, the already depressed market for vacation homes will deflate even more.

Previously, any capital gains on your primary residence were excluded up to $250,000 for singles and $500,000 for couples. A primary residence was defined as any home you had lived in for two of the previous five years. The "prior rule" gave seniors moving to a new residence three years to make the move permanent. During that time they could still sell their original residence and take advantage of the exclusion.

It also allowed seniors who had a vacation home to move there and sell their primary residence. After two years their vacation home qualified as their primary residence. Young grandparents approaching retirement could buy a retirement home as a vacation destination while they were still working. After retirement they had time to sell their original home and in two years gain a full exclusion for their new residence.

With the new rule, primary residence is not something you can qualify for. Rather it is just a percentage of the time you live there.

The new law eliminates the capital gains exclusion, prorated on the amount of time a home was not your primary residence. After January 1, every day you aren't living in a home starts adding to the percentage of capital gains tax you will ultimately be obliged to pay.

Also, capital gains are no longer waived on a primary residence unless it has always been your primary residence. Starting in 2009, the percentage of time a home is not your primary residence will be the same number used to calculate the amount of capital gains that won't be waived. For example, if you own a house for ten years and have only lived in it for five, you will have to pay taxes on half of the capital gains when you sell it.

These are the same capital gains that President-elect Obama promised during his campaign to raise from 15% to 28% on the most productive citizens. Some states (e.g., California) tax capital gains at ordinary income tax rates, adding an additional 9.3%. So people who make significant contributions to society could easily be facing taxes of 37.3% on gains that are mostly inflation.

This isn't just a problem for the wealthy. You can be pushed into the top 1% of income tax payments simply by selling a house in California. Middle-class couples routinely get hit with unexpected taxes selling a home with capital gains well over the $500,000 exclusion. Because it is not a onetime exclusion, couples who have stayed in the same house for 40 years get socked with the tax, whereas couples who move every decade have multiple chances to realize smaller gains that are under the limits. People who move frequently shouldn't be rewarded with a tax break.

Here's another factor to consider: Home appreciation is mostly inflation. Taxing government-created inflation as so-called gains isn't fair. Even according to the official inflation numbers reported by the government, the equivalent of a million-dollar home today was a $179,154 home in 1970. Calling the $820,846 inflation a capital "gain" is ludicrous.

Class envy is equally mindless. Capital gains on real estate affect your finances even if you don't own a second home. The housing market isn't segmented into primary and secondary residences. What depresses the values on second houses depresses the value of all homes.

The second-house class is the very group that could have helped shore up today's slumping housing market. Speculators who would have bought real estate at the current depressed prices will find this option far less attractive in 2009. Instead the new law will encourage them to sell their current residence (taking the full deduction) and move into their second home. Then their second home will become their sole and primary residence, and they won't have to deal with future nonexempt capital gains taxes. Ask your financial advisor about the potential costs of continuing to own two homes. If you delay, you may be holding an unused vacation home until you die just to avoid this new tax burden. And as a result, your heirs will inherit the house with a step-up in cost basis.

Because of the law, thousands of additional homes will be added to the market, softening the demand for housing even further. It is as though a shortage of people are buying real estate and we've passed a one-per-customer tax incentive law. There is no reason to discourage what no one is willing to buy. The new legislation will probably push home values to new lows during 2009.

Why the law was changed is unclear. The old law was difficult to abuse. Those who were rapidly turning over real estate could not take advantage of the law. If someone tried to flip 25 homes, it would take 50 years. The new law doesn't make any sense, but if it did make sense, it probably would not be Congress.

The new law won't bring in much additional revenue either. But it will complicate record keeping and tax returns for anyone selling a home they have not lived in continuously. As a result of these disincentives, buying or selling vacation homes will become less desirable.

This legislation graphically illustrates the deadweight costs of taxation. Rarely is the concept so clear. The law will remove much of the value of vacation homes from the economy without collecting much additional tax revenue. All pain, no gain. It teaches us a sad lesson about the destructive power of taxation.

Vacation homes represent an expense that can easily be let go in challenging economic times. Many families own a vacation home during the season of children or young grandchildren. After that, the travails of maintenance and repairs outweigh their pleasure in the home. Management companies remove much of the headache but make the economics even more problematic.

In times of rising home values, the investment in a home at least kept up with inflation, but with the new laws the government will tax you on that inflation. As a result of these changes, consider simply renting a vacation home and letting someone else pay the capital gains tax.

Comments

Umm, since it wasn't obvious to Marotta, the rule was changed because people were gaming the residency rule to convert vacation properties into primary residences in order to gain the tax break on their sale. (Recall, prior to 1997 this tax break didn't exist -- to avoid the capital gains you either had to roll the money over into a new house or take a limited once in a lifetime tax exemption.) I have a tough time seeing this as an unfair rule. I mean if the tax break is framed as being about your primary residence, then how is this unfair? By the way, the rule, as I understand it, only impacts years after 2008 where the vacation home wasn't your primary residence. In other words, all years prior to 2008 where it wasn't your primary residence don't factor into the pro-ration. Of course, double check me on that one, but I think that's the case.

I may agree with Marotta's view that homes shouldn't suffer capital gains given how little (aside from this bubble period) of the appreciation is due to anything other than inflation. But that's for a different day. You would think an asset management group could get passed their ideological commitments a bit and do some better analysis. And that first sentence, my goodness! I see Marotta is back to its old style posts that seem only to convince people to never put their money with them. Maybe a little less flamethrower and a bit more analysis? The first sentence is ridiculous. Unless the reason you were owning the vacation property was to flip it for investment purposes AND you were planning to game the system by moving into it temporarily and claiming it as your primary residence before you sold it, I wouldn't worry terribly that now it is untenable to own two homes. Goodness grief. FMF, put me back in the camp of questioning why you let these people guest post again!

[Craig]

This just kills me!

My wife and are planning on purchasing a new home in 2009, but keep our old house and rent for a couple of years hoping prices would come back up and then sell for a better return.

We are able to purchase the new home without having to sell first. That gives us more leverage and less complication when purchasing. Now we'll have to sell our house first to avoid this lovely new tax.

This may keep us out of the market in 2009. If we do decide to purchase, it'll force us to put a house on the market that would not have been.

- Craig

[Kim]

"These are the same capital gains that President-elect Obama promised during his campaign to raise from 15% to 28% on the most productive citizens." Productive citizens?! ROFLOL! "Productive citizens" - wow that's a good one. I'd be willing to bet that at least 80% of people with second homes purchased them with no money down liar loans. Give me a break! They're a huge part of the problem!

[Jeffersonian]

Being one of the "Productive Citizens" who purchased a vacation home as a future retirement home, I take exception to being taxed on an investment of hard-earned money used to purchase this home. I bought this house when I was paid off on deferred vacation and an employee stock purchase plan after my company was bought by a Fortune 100 company. Instead of throwing it away on vacations and new cars, I put it into a future retirement home. Now, the same Fortune 100 company is shipping my job and my 1300 co-workers jobs to Mexico (thank you NAFTA and President Clinton), so we can join the unemployed next year. I'll still get to pay that extra capital gains tax when I sell my first home because I can't afford the property tax on it anymore after 30 years. Not to worry though, the healthcare coverage that I am losing with my job will be paid for by the rest of the working taxpayers. Maybe a former engineer can get a job paving roads with President Obama's new infrastructure workforce.

[poor boomer]

FMF said:

What depresses the values on second houses depresses the value of all homes.

As a renter with no hope of buying a home, I gotta ask: exactly how is this a bad thing for renters with no hope of buying a home?

Has anyone noticed that the rules are usually rigged in favor of property owners? (Check the fine print in your zoning and tax laws. Homeowners get (almost)all the tax breaks and the zoning laws are written to protect homeowners, not renters.)

FMF will be tickled to learn that homeowners can take the Michigan Homestead Property Tax Credit (a 'circuit breaker' which rebates a portion of property taxes) on the basis of property taxes BILLED, even if the taxes were not actually PAID.

Is this a great country or what?

[Sarah]

"Taxing government-created inflation as so-called gains isn't fair."

So-called gains? You mean the money that otherwise goes into your pocket for you to spend? Gosh, who knew those weren't gains?

(And, um, you realize that inflation affects the value of taxes paid as well as house values?)

Sometimes I think the person who writes these blurbs is convinced that the audience here is actually mentally disabled.

[spivey]

poor boomer - No one was talking about how this would or would not benefit renters with no hope of owning a home. It's probably a good thing for you. Deflated property values will most likely lead to cheaper rent.

Rules that are 'rigged' to favor property owners are usually in place to encourage homeownership because of its stabilizing effect on communities. Government uses incentives to encourage certain behaviors. Although this can be frustrating for those who may not be able to engage in those encouraged behaviors (homeownership in this case), it is not due to some conspiracy aimed at keeping renters poor by favoring homeowners.

Have you ever wondered why people who do not own property can vote to increase property taxes? That doesn't seem fair either, does it?

I definitely don't think we should implement a timocracy. I just think it's absurd when people consider rules only as the rules affect themselves, instead of considering why the rules might have been put in place.

Yes, this is a great country, thanks for asking.

[Mark]

The only point worth discussing in this rant from Marrotta is the fairness of taxing inflation-induced profits as gains.

If we start on the second-home exception, what if my 50-foot yacht appreciates? Surely I shouldn't have to pay tax because I choose to sail a boat instead of buy a second home. And what about my stock sales? Part of that gain is inflation-driven too.

And I assume everyone knows that interest rates are higher during inflationary times - so why are we paying tax on bond and CD interest that is just bringing our purchasing power back up to it's previous value?

Even the non-taxing of profit for a first home, like the deductibility of mortgage interest, is a way to steer social policy - i.e., government desire for high levels of home-ownership.

If the government wants us to own two homes, it will provide a tax incentive.

[Param]

I agree with some of the other comments - the inflation-induced profits being taxed as capital gains seems ridiculous - irrespective of being applied to houses or other investments.
In my country, houses if sold after 3 years of purchase qualify for long term capital gains rate (20%). The good part is that purchase price is indexed to inflation to arrive at the final capital gains.
However, selling before 3 years makes it short term capital gains, which is taxed as regular income (tax rate 10-30%), and you do not get inflation adjustment.
I feel this approach is fair for home-owners and penalizes "investors" reasonably enough.
I thought tax laws in my country were stupid, but looks like in this case, IRS can learn something...

[Rod Ferguson]

Folks - this will only apply if you happen to sell your home for cash (i.e. - don't roll it into another home.) If you are looking to just upgrade (or if you are going to buy a second home as a retirement home with no intention of selling it) then it doesn't apply. I will shortly be a second home owner, but will have no intention to sell it as it'll be my little retirement getaway instead of a quick-cash flip. This won't affect me at all. As for my heirs, well, tax laws change yearly; it's kind of naive to think there won't be future rules that change the tax rates. That's one of my biggest arguements in favor of having a portion of your portfolio post-tax; to think that current tax rates and rules surrounding pre-tax investments will never change is also naive.

[FMF]

Poor --

You realize that this is a guest post, right? I didn't say that, the author did.

spivey said:

"Have you ever wondered why people who do not own property can vote to increase property taxes? That doesn't seem fair either, does it?"

Ah, an interesting question. FWIW, I support transparency in property taxation and an explicit pass-through of property taxes to the renter. This would impose an explicit cost on renters when property taxes are increased, and presumably would give renters pause before voting to increase said taxes. The flip side, however, is that property tax cuts would put money in the pockets of renters, something which has never been the case. (Currently, the common conservative tax tradeoff - reducing property taxes and increasing sales taxes - is guaranteed to make every renter worse off. So I enthusiastically welcome any explicit assignment of property taxes to renters.)

This is actually commonplace in commercial properties, where the tenant explicitly pays the property taxes (so-called "triple net" leases)..

In residential, property taxes typically are bundled into or embedded in the rent charged. As a result, while renters might experience a temporary lag between the time property taxes go up and the time their rent goes up, renters never receive in their pockets the savings of property tax cuts.

Note that my solution would resolve the issue of renters getting a free ride by voting for higher property taxes.

Having said that, the sad (for me, anyway) reality is that renters have a much lower voting rate than do homeowners. Basically, renters as a group lag way behind homeowners on a variety of demographics which correlate with voting. (For example, median renter income is <50% of median homeowner income; renters, lacking housing tenure, have much shorter length of residence than do homeowners, etc.) In a census survey I found at work years ago, renters cast approx one-sixth of the votes in 1982 elections, while comprising one-third of the population. So I doubt renters are, to any significant extent, imposing higher property taxes on unwilling homeowners.

Particularly interesting to me is the Michigan nonhomestead tax, which is levied on rental property but not on a homeowner's primary residence. This is a school tax and is 3x the base school tax rate on all property. (So the total school tax rate on rental prop is 3x + 1x = 4x the rate on owner-occupied primary residences.

Since the vast majority of homeowners do not own nonhomestead property, the nonhomestead tax is not levied on their homes, and thus represents free money to homeowners with children in school.

Question for you: Is it fair that homeowners WHO DO NOT OWN NONHOMESTEAD PROPERTY can vote to levy this tax?

[poor boomer]

Sorry about that, FMF -I was just trying to bat out a quick reply (as I often do; hence frequent typos) and forgot to properly attribute the OP. That is, when I wrote it, I knew the OP was a guest post but my multitasking execution was flawed.

p.s. I also wrote the above rant in reply to spivey; I was careful enough to have checked my reply for errors, and forgot to notice that I had failed to put in a name, which I had intended to add after concluding the rant.

spivey also said:

"Rules that are 'rigged' to favor property owners are usually in place to encourage homeownership because of its stabilizing effect on communities. Government uses incentives to encourage certain behaviors. Although this can be frustrating for those who may not be able to engage in those encouraged behaviors (homeownership in this case), it is not due to some conspiracy aimed at keeping renters poor by favoring homeowners."

Rent control arguably has an even greater stabilizing effect on communities, based on the stories I've heard out of NYC.

How is the "incentive" offered to an affluent person (who has the option of buying or not buying a home) not a penalty to the person who must pay more as a result of lacking similar options?

You are correct that "... it is not due to some conspiracy aimed at keeping renters poor by favoring homeowners" yet it is a penalty with a cost, nonetheless.

It is not about, and never has been about, renters. This country has been all about property owners. That's why, when government effects a "taking" of your property, the Constitution entitles property owners to "just compenmsation" while renters get squat. It's all about homeowners - should the latest bailout have been any surprise??? - and if renters get hosed, that's just collateral damage and tough luck.

p.s. Did you know that this country still has elected public offices which are restricted to property owners?

[spivey]

poor boomer-

I think transparency in property taxation sounds like a good idea.

If property owners were split 50/50 on some tax, the 16% of votes cast by non-property owners could definitely have an impact. At any rate, I am not saying that homeowners are being victimized due to this practice, just that it seems a little odd at face value. As for the "NONHOMESTEAD PROPERTY TAX" you mentioned, I can't speak to its fairness, but it definitely doesn't sound like a good idea to me. It sounds like it would just increase costs for landlords and renters alike and create unnecessary friction in the rental property market. I suppose one could argue that it is unfair because it is a tax imposed on a minority (landlords and renters) by a majority (homeowners with just one home), but I don't know the numbers there and I am sure it varies by location.

As far as incentives go, I did not say that it wasn't effectively a penalty to those who do not have the option to participate. I said that I can understand that it would be frustrating to be unable to engage in the encouraged behavior. It does amount to a penalty to renters, but the net social benefit can still be worth having those rules in place.

I would be interested in reading about rent control's effect in stabilizing communities, but it would be a hard sell to convince me that it is comparable to the positive external effects of homeownership (I might be slightly biased).

I don't understand why a renter is due anything when the government exercises eminent domain. Unless I am mistaken (a distinct possibility), the "just compensation" is only for the land itself, not for the inconvenience of moving and such. So how would renters be entitled to anything in that case?

I was not aware that there are public offices that are restricted to property owners. Where are they?

spivey said:

"If property owners were split 50/50 on some tax, the 16% of votes cast by non-property owners could definitely have an impact."

I think the results depend largely on the nature of the tax and the renter's personal rental experience. For example, I am steadfastly opposed to the nonhomestead tax and cannot think of any scenario under which I would vote for it. (Or, more emphatically, I cannot imagine any scenario under which I would refrain from voting AGAINST it.)

Some renters might think their landlord hosed them, and enjoy the opportunity to 'stick it to' their landlord in the form of higher taxes. Or someone might have a very good deal and specifically NOT want to raise their landlord's taxes.

More transparency and honesty and moderation could only improve the tax issue. It's hard to sympathize at tax time with landlords who stick it to tenants because they can - but it's also hard to NOT sympathize with reasonable landlords.

Another question: As someone who has voted against the nonhomestead tax at every opportunity, should I be excluded from voting on it because I don't own property? If I can't vote on it, how about a rebate for the amount of the tax I paid but didn't get to vote against??

Many Western states have "soil and water conservation districts" (which mostly originated in the Depression era). In Oregon, qualifications for elected board members include owning or managing at least 10 acres of land. That was a surprise to me.

p.s. In NYC, rent control has the perverse effect of stabilizing people for decades because controlled rents over time lag far far below uncontrolled rents. (Imagine staying in an apt 40 years for $150/mo while uncontrolled rents soar to $3000.) Stabilizxing neighborhoods might be a good thing but in NYC it might be too much of a good thing.