A FEDERAL court decision is focusing new light on an issue that could affect large numbers of American homeowners who expect to cash in their equity tax-free.
In a nutshell: Is it possible for you to own two or more homes, but fail to qualify any one of them as your "principal residence" for federal capital gains tax purposes? Could you be forced to pay tens of thousands of dollars in capital gains taxes because you have multiple homes, but no principal residence?
A U.S. District Court in Arizona says the answer is yes. And that answer should set off alarm bells among the millions of Americans who own at least two houses, and plan to pocket hefty sale profits tax-free from one or more of them.
Second homes account for about 10 percent of new-home construction in the United States, according to realty industry data. Many of those second homes are purchased for recreational or seasonal use initially, but for tax purposes eventually will be converted into their owners' primary homes. This is especially so for second homes built or purchased by pre-retirees in their 50s and 60s.
The federal tax code contains powerful financial incentives for this strategy. It allows you to keep up to $250,000 tax-free from the sale of a qualified principal residence if you file taxes singly, and up to $500,000 if you are married filing jointly. But you have to pay capital gains taxes on any sale profits from second homes and others that are not your principal residence.
So what is a principal residence? The answer seems obvious: It's where you live most of the time. However, to qualify for the $250,000-$500,000 capital gains exclusions, the property needs to be the home that you own and use for an aggregate two years out of the five years preceding the sale.
In the recent Arizona case, a married couple had owned a succession of houses during the 1990s - one purchased in Wisconsin in 1993 and sold in 1998, one in Georgia sold in 1996, and a home in Arizona. During the five-year period when the couple owned the home in Wisconsin, they could document that they were physically present on the property for 847 days - mainly between May and September.
They lived in the Georgia house for 563 days and in their Arizona house 375 days during the five years preceding sale of the Wisconsin home. Considering time of occupancy alone, the Wisconsin house clearly appeared to be their principal residence for tax purposes.
