Changes to Capital Gain Tax Treatment of a Primary Residence

Just when we think we have the income tax laws regarding real estate figured out, the federal government has to go and change them again! This time the changes come as part of the 2008 Housing and Economic Recovery Act (HERA), H.R. 3221, an attempt on the part of government to help individuals impacted by the current mortgage crisis without spending money to do it. It's called "revenue neutral", which means that they have to collect more money from somewhere to pay for it.

The additional collection relative to real estate comes from a change in the way profits (capital gains) from the sale of a primary residence are (or are not) taxed. Currently, if a person sells a house for a profit (capital gain) after living in it as their primary residence for 2 of the past 5 years, there is no capital gain tax due on $250,000 of the gain for a single person or $500,000 for a couple. They are free to do whatever they want with the money and there are no age restrictions.

Americans are a creative people, particularly when it comes to avoiding taxes, and during the recent boom, this tax provision provided an incredibly easy way to make money. Let's look at a simplified example:

A couple owns a house (their primary residence), a vacation home and a rental house. They sell their primary residence, take $500,000 in tax-free profit and move into their rental house. They live there 2 years, sell it, take $500,000 in tax-free profit, buy a home where they want to retire and move into their vacation home. They live there 2 years, sell the former vacation home, take the tax-free profit and move into their retirement home. 3 sales, no capital gain tax.
The sale of a former rental does have some tax implications regarding recapture of depreciation, but that has been minimal relative to the potential for gain.

Congress has decided that this scenario does not fit the original intent of the law, which was to eliminate capital gain taxes on the increase in value of a person's home. As of January 1, 2009, there will still be no capital gain tax due on a profit generated by the sale of one's personal home where they have lived for 2 of the past 5 years, with the following exception:
If that home was converted to a personal home from a rental or vacation property, capital gain tax will be due on that percentage of the gain equivalent to the percentage of time that the house was used other than as a primary residence since January 1, 2009.

For most homeowners, this change will be of no concern, but many knowledgeable people have incorporated this tax provision into their financial planning. It has always been important to talk with your financial advisor or accountant before making a decision to sell property, and never more so than now.

Private Equity Professionals and Carried Interest - Tax Treatment Now and in the Future

Carried interest is the profit earned on private equity investments by a deal-maker in a private equity house. Often known as carry, it allows these professionals to receive up to 20% of the profit from a company they sell. The carry can be a significant portion of a private equity professional's total compensation.

Private equity firms are typically structured as investment partnerships where the general partners manage the firm's fund on behalf of the limited partners (the investors). The firm then uses the fund to purchase an equity position in a number of companies. When these equity investments are sold, the investors typically receive 80% of the profits and the managers collect the remaining 20% (known as the carried interest).

Current Treatment - Carried interest profit is eligible for capital gains taper relief, which is why it is currently taxed as a capital gain at 15% for both investors and managers. Investment partnerships have long maintained this lower rate.

Debate and Uncertain Future Outcome - In recent years, lawmakers have been pushing to tax carried interest as ordinary income, which would set a much higher rate than 15%. Supporters of higher taxing of this interest, such as the Coalition for Tax Justice, have argued the issue is tax fairness. A bill proposing a change would require fund managers to treat carried interest as ordinary income received in exchange for the performance of services to the extent that the interest does not reflect a reasonable return on invested capital. The bill would continue to tax carried interest at capital gain tax rates to the extent that the interest reflects a reasonable return on invested capital. President Obama's 2010 released budget proposes to raise taxes on carried interest to more than 39%, effective 2011.

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