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When 2008 rolls around, investors who anticipated a capital gains tax exemption on the sale of their investment real estate may run across a kink in their plans. HR 3648, a bill working its way through Congress, would alter the requirements for exemption on primary residences so that many investment properties will no longer qualify, leaving investors to pay a capital gains tax from which they would previously have been exempt.

Since 1997, savvy investors have avoided capital gains on investment real estate by ensuring that the property qualifies for an exemption.  The requirements are relatively easy to meet: As long as the seller has lived on the property for at least two out of the past five years, it qualifies as a primary residence and is exempt from capital gains taxes. Because of this, many investors opt to either rent out the property and then move into it themselves for two years before selling, or live on the property for two years before renting for the following three.

Capitol building at night
HR 3648 would alter capital gains tax exemptions for homeowners
HR 3648, or the Mortgage Cancellation Tax Relief Act, passed the House of Representatives Oct. 4 and is up for consideration in the Senate. If the bill becomes law, its tighter restrictions may require a new game plan from investors.

The primary intent of HR 3648 is to assist homeowners who find themselves facing foreclosure. When a homeowner opts for a short sale, they are often “forgiven” the difference between the sale price of the property and the balance on their mortgage, known as the deficiency. Under current legislation, the lender must report the forgiven deficiency as 1099 income that can be duly taxed, heaping a greater financial burden onto an already struggling taxpayer. HR 3648 would exclude this “phantom income” from the sellers’ gross income, exempting them from taxation of their forgiven debts on principal residences.

But this relief for struggling homeowners could be troublesome for investors. In order to offset the taxes lost because of this change, the proposed legislation would tighten the requirements for exemption on capital gains from a primary residence.

“Taxpayers are currently allowed to exclude up to $250,000 ($500,000 for married couples filing jointly) of the gain realized on the sale of a principal residence, generally as long as the property was used as a principal residence for at least two of the five years prior to sale. The legislation would reduce the exclusion for some residences that were not the principal residence for all of the prior five years,” according to the Congressional Budget Office.

If HR 3648 passes, investors who rent out a property in which they once lived would no longer be eligible for a full exemption of capital gains taxes. “Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence,” according to the Committee on Ways and Means.

House for sale
Investors may move to buying short sale properties or using 1031 exchanges
Homeowners who were absent from their homes because of unforeseen circumstances may still be eligible for the full exemption, but it is unclear if they would be able to rent out their residence during this time and still maintain the exemption.

Although HR 3648 may be undesirable for some investors, it may benefit others, particularly those who buy short sale properties. With no phantom income tax looming in their futures, struggling homeowners may be more willing to pursue a short sale for their home rather than await foreclosure. Investors could potentially use this information to their advantage when negotiating with sellers in order to gain permission to pursue a short sale with the bank and ultimately purchase the property for a lower price.

Investors who stand to be affected by HR 3648 would be wise to look into ways to protect themselves from this resurfacing capital gains tax. One possibility is through 1031 exchanges. (For more information on 1031 exchanges, see Top 10 1031 Exchange Considerations, Defer Taxes with 1031 Exchanges and 1031 Exchanges: Top 5 Little-Known Uses.)

When an investor opts for a 1031 exchange, the income from the sale of the property can be immediately invested into a replacement property without the investor ever personally coming into possession of the funds. Depending on the value of the replacement property, investors can defer taxes on all or part of the gains from the sale of the property. For the concerned investor, a 1031 exchange could be a prudent way to avoid the taxation changes inherent in HR 3648 while continuing to invest in new properties.