Yesterday, I discussed the current House bill that permanently excludes mortgage debt discharge income. See Cancellation of Debt Income on Mortgage Loans: H.R. 3648. The House Ways and Means Committee approved the bill yesterday on a voice vote, in spite of its inclusion of an offset provision which Republicans have typically objected to.
The cost of the mortgage loan forgiveness exclusion is about $2 billion. The revenue provision in the bill offsets that cost by reducing the gain exclusion on sales of principal residences under section 121. Under the offset, the gain that can be excluded from income on a sale or exchange of a principal residence is reduced proportionately for periods that do not relate to use as the taxpayer's principal residence. Here's the description of the offset provision provided by Ways and Means in the short summary of the legislation.
The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.
If Congress does enact a mortgage debt discharge exclusion, it should enact an appropriate offset and the gain exclusion provision may well be the right one to consider. Clearly, the current section 121 rules permit a form of gamesmanship whereby taxpayers with second homes that they intend to sell can move their principal residence to those homes for a period of two years, sell the home, and exclude the entire amount of gain, which may relate almost entirely to the period of ownership before the house was used as a principal residence. A nifty tax avoidance mechanism that should be prevented. The offset provision does prevent the avoidance: excludible gain would be limited to the appreciation during the period of use as a principal residence and would not include the appreciation (which might be the most substantial portion) during the period of use as a vacation home prior to conversion to principal residence status.
Thus, while the provision adds another complication to the Code, and will undoubtedly disappoint homeowners who foresaw being able to play this game several times over the years and enjoy constant upgrades in their vacation properties at no tax cost, it seems to be a good idea independently of the mortgage debt discharge provision.
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