Capital gains tax loophole may not be what you think

The Internet is a wonderful thing, with a lot of useful applications, but it does have a few downsides. One of them is that when information becomes outdated, it usually remains there on the Web, waiting to potentially mislead people.

I was reminded of this recently, during a conversation with a young man who was doing some household repairs for me. He mentioned that he and his wife were thinking of selling their small home and buying a bigger place for their growing family. If they did that, he mused, they might hold onto their old house and rent it out.

And then he hit the kicker: "And years from now when the kids are grown and we're ready to sell the new house, we can move back into the old house for two years, and then we won't have to pay any taxes on the sale."

Unfortunately, I had to burst his bubble. What he was describing used to be a very nice loophole, but then things changed.

Here is how the strategy used to work. As you may know, when you buy a property and then sell it later for more, you pay capital gains tax on the profit. But if that has been your primary home for two years, there is an exemption from capital gains tax. The exemption is $250,000, or double that for a married couple.

So, if my wife and I buy a house for $300,000, and live there as our primary home, and then years later we sell it for $600,000, we don't have to pay any capital gains tax. Our combined exemptions of $500,000 are more than the $300,000 profit on the sale.

But what if we rent it out for a few years? The old rule was that as long as we lived in it for two years out of the last five years before we sold it, we would still get that exemption.

Let's take that young man's situation and move it back in time. He and his wife bought a house for $150,000 and lived there for 10 years. Then they bought a new house and moved into that one, and lived there for the next 18 years, while they rented out the old house. Next, they moved back into the old house for two years, selling the newer one. They wouldn't pay any capital gains tax on the newer home, because they applied the exemption. Two years later they sold the original, smaller house for $500,000. They would have been able to exempt from all the sales proceeds on both homes. That is, under the old rule.

I keep emphasizing that that was the old rule-I'm even going to put it in caps: THE OLD RULE-because a lot of people think you can still do this. Unfortunately, sometimes when a loophole is just too juicy, they close it. And Congress did that several years back.

Here's the new rule. If you are renting a house out, and then you move into it for the requisite two out of five years before selling it, you can still get an exemption. It is not, however, the full exemption that you used to get. It is a fraction based on how long you lived in the house as opposed to how long you rented it out.

So if that young man lived in the smaller house as his primary home for 10 years, rented it out for 18 years, and then lived in it again for two years, he would get a 40% exemption since he lived there for 12 years out of the 30 years he owned it (which is 40%). Which is a nice exemption to have, but not nearly as good as the old one.

There are a lot of details that go into calculating capital gains on a property sale, including depreciation, improvements, costs of sale, and so forth. Please don't rely on this article in making a decision such as that one. This is the kind of thing you work out with an accountant.

And please, any time you get information off the Internet, make sure it's current. There is a lot of old gunk in those cyber webs.

Kenneth Kirk is an Anchorage estate planning attorney. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account. As they say on the Web, "I said what I said."