The Capital Gains Loopholes Are Beginning to Shrink

The Capital Gains Tax has always been a hefty portion of the equation when you invest in real estate. Up until now, the benefits were generous for residents or investors who lived in their homes. Now, however, the tables seem to be turning on the investors.

If you are a homeowner who lives in their primary residence for at least two years and you're single, the capital gains allowance for you is $250,000. If you are living under the same circumstances, but married, the same allowance is $500,000. That has not changed.

Capital gains are assessed on the profit made when selling your house. That is not, generally, equal to the amount of sale.

There has been a change in the law under circumstances where the owner purchased the home, and then rented it for a period of time before taking possession of it as their primary residence for at least two years.

It was once possible to sell the home under these circumstances and convert the profit from renting the home into a tax-free income under the capital gains protection.

Even though the owner has lived in the home as their primary residence for at least two years, as the tax law requires, the time during which it was rented is now considered a taxable period. The new law states the capital gains allowance is to be tabulated pro-rata, and that it shall be divided between the time it was taxable (while it was rented) and the time it was not (while the owner lived there).

Let's draw an example of how this works. You buy a house in June of 2009 for $400,000. You rent it for three years and then live in it for two before selling it in June of 2014 for $700,000. So, you have a net gain of $300,000 for our example. Under the prior set of tax laws, you could use your allowance as a single person to the tune of $250,000. That means you would only have to pay tax on $50,000.

Under the new law, you can claim your capital gains allowance of $250,000, but only against two fifths of the $300,000 you made selling the property. This means that your allowance covers only $120,000 of the money you got for selling the property. That leaves you in the bucket for capital gains tax on the remaining $180,000.

You are now going to pay capital gains tax on $180,000 as opposed to $50,000. Some change, huh?

Capital Gains Tax Loopholes Shrinking

Seems the new 2008 housing bill was not a savior for all of us - like a scorpion there is a little kick in the tail! However, struggling home owners can breathe easy, the kick is not directed at them, in fact, it is aimed at real estate investors.

Whoever it is aimed at in the real estate market, it will not give the realty world a much needed boost as it is yet another deterrent to buying a home, this time aimed at investors.

Capital gains tax is always part of the profit and loss formula when investing in realty, and the levels were generously high for both investors and regular residents who live in their home. Residents still have the same concessions but now it has changed for investors.

To re-cap on the capital gains that was - and still is for residents owning one house in which they are living and have lived for two years: the allowance on capital gains is $250,000 for a single person and $500,000 for a married couple.

Capital gains taxation is only charged on the profit made on the sale of the house, which is usually not necessarily on the actual sale price of the house.

However, there is a marked change in the taxation laws for people who buy a home and rent it for a while and then move into the home for a two year period prior to selling it.

It used to be possible to sell the home and convert all the profits that were made when it was a rental into tax free income under the capital gains umbrella. The new law has changed all that.

Even though investors may have lived in the rental home for two years before selling it, their capital gains allowance is no longer sacred. The new law says it must be calculated pro-rata and is divided between the taxable years that it was a rental property and the non taxable years when the owner lived in it.

This new rule comes into effect on January 1st 2009 and this is a hypothetical example of how it might look. You buy a home in June 2009 for $400,000 and you rent it out for three years, live in it for two years and sell it in June 2014 for $700,000. (Dream on!)

This means that you have a capital gain of $300,000 (assuming that nothing can be used as tax write-offs). Under the old system you could be exempted from capital gains tax by using your single person's allowance of $250,000 capital gains exemption. This means that you would have only had to pay capital gains tax on the last $50,000.

This no longer applies; now the tax department will tell you that yes, you may claim the capital gains exemption for the two years that you were actually living in the residence i.e. you can claim two fifths of the $300,000 profit against your own personal allowance of $250,000. This calculates into $120,000.

However, for the other three years -when it was a rental property - the capital gains tax is applicable. Therefore, you will pay the percentage rate of capital gains tax on the remaining $180,000 (three fifths) of the profit of $300,000 that you made when you sold the house.