Law changing on 2nd-home tax liability

Q: My mom, who is in her 70s, has a beach place she has used as a second home for years. We go there every Christmas, and she lets all of us use it for weeks at a time as our vacation spot.

Her tax adviser suggested that she plan to sell her current home and retire to the beach in a few years. She would make her vacation home her permanent home for at least two years to reduce the tax liability on the appreciation of the beach home if or when she decides to downsize or move into an assisted living facility.

He said this strategy would allow her to avoid capital gains tax up to $250,000 on her current home and again up to $250,000 on the eventual sale of the beach house.

Now he is pushing her to place her current home for sale and make the beach home her permanent residence before the end of this year. This is a lot for her to do in a few weeks, especially during the holidays. He said this will be very advantageous due to a change in the tax law. If this will save a lot of money, fine, but does she really have to make this move right now?

I've done some research on the tax change and understand the change in general but can't find the details to know how much money we are talking about saving if mom moves before the end of the year versus sometime in the future. Can you explain this and provide an example, assuming the appreciation on mom's current home and the beach house is at least $250,000?

A: There was a change in tax treatment for capital gains from the sale of a second house included in the housing bailout bill signed into law in July. The tax change doesn't take effect until Jan. 1, so some tax advisers may suggest that clients with a highly appreciated second home make it their permanent residence now to save on taxes later.

Under current law, as long as a second home is your permanent place of residence for two of five years, up to $250,000 of capital gains ($500,000 for those filing married jointly) may be excluded from tax upon the sale of the home. A single person could sell his current residence and avoid tax on up to $250,000 of appreciation, move into his vacation or rental home for two years or more and then avoid tax on another $250,000 of appreciation upon the sale of that home.

As of Jan. 1, the capital appreciation on vacation or rental homes may be subject to tax even if they become a permanent residence for two or more years. The taxable amount will be determined by the number of months the home was used as a principal residence after 2008 compared to the total time you owned the home after 2008.

Ownership before Jan. 1 is considered non-qualified and is not used to determine the taxable amount. Moving sooner than later makes sense, but I don't think your mom will save a significant amount of tax if she doesn't make a move before year's end.

The following simplified example may help clarify this new tax treatment of second homes and rentals:

A 40-year-old homeowner buys a second home for $200,000 in 1999, retires and makes it a permanent home at age 60 (year 2019). At age 80 (year 2039), the home is sold for $700,000. After Jan. 1, 2009, it was a second home for 10 years and a permanent residence for 20.

Up to 66 percent of the gain could be excluded from tax (20 years/30 years), and the remainder would be subject to long-term gains tax. Since 66 percent of the $500,000 gain is $330,000, if the homeowner is single, only $250,000 of that gain would be excluded from tax. If the owner were married, the full amount would be excluded because of the larger exclusion for married couples.