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The Tax Prophet Newsletter   Issue # 64 August, 2008,

REDUCE TAXES!
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In This Issue:
Introduction
Loophole
New Restriction
Example
Limitations
Planning
Conclusion


Residence Exclusion --
New Limitation


Introduction

The principal residence exclusion ("exclusion") is a valuable tax break enjoyed by home owners.

In general, it permits excluding up to $250,000 in gain ($500,000 for joint filers) when a principal residence is sold, provided the taxpayer owned and lived in the residence for at least 24 of the preceding 60 months prior to sale.

Loophole

On July 30, President Bush signed The Housing Assistance Tax Act of 2006, which closed a purported loophole involving taxpayers owning multiple homes who used the exclusion in serial fashion by moving into one home for two years, selling it, then moving into another property, often repeating the process.


New Restriction

After 2008, the exclusion no longer applies when a property is used as a vacation home or a rental ("non-qualified use"). The exclusion is reduced by a fraction: the numerator is the period of nonqualified use after 2008 and the denominator is the entire ownership period.


Example

If a married couple (filing joint returns) purchases a property after 2008, using it as a vacation home for eight years, then as a principal residence for two years before selling it, the exclusion is reduced by 80% (eight years of nonqualified use after 2008 divided by ten -- the total number of years owned).

Thus a gain of $500,000, excludable in full under the old law, is now taxable as to 80%, or $400,000, under the new law.

Note: if the property were rented, a recapture tax of 25% federal applies to the amount subject to depreciation.


Limitations

The new law does not apply retroactively: non-qualified use begins after 2008. Homeowners may still purchase and sell homes every two years and take advantage of the full exclusion, as long as they do not already own the replacement residence.

Amounts attributed to non-qualified use remain taxed at favorable capital gains rates (currently 15% federal).


Planning

The law focuses on "ownership" of the vacation home or rental by the taxpayer. Clearly, property owned by the taxpayer through a grantor trust or an LLC taxed as a disregarded entity will be attributed to the taxpayer, but what happens when property is not considered owned by the taxpayer?

For instance, property received by gift or inheritance is not previously owned by the taxpayer, and the same is true for property acquired in a tax-free (Section 1031) exchange. In addition, what about property held by an LLC (taxed as a partnership) or by an irrevocable trust (both are separate entities under the tax code)?

If those properties are distributed from the entity to the taxpayer (generally, this can be accomplished on a tax-free basis), the entity's nonqualified use should not be attributed to the taxpayer.


Conclusion

The new restriction is estimated to affect only about 1,000 taxpayers annually, which indicates that many taxpayers should be able to circumvent these rules with proper tax planning.

Also, will the Treasury spend the time and resources to draft detailed regulations to combat the planning devices mentioned above, when the new law will produce little new revenue?

Upon close examination, the new law appears to be just one more tax trap for the unwary -- another "gotcha" provision -- rather than a substantial tax-raising measure.



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All contents copyright 2008 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.