Back in the day when real estate prices went in only one direction (up), selling your home could result in a whopping tax bill.  So Congress took pity on taxpayers, and allowed the exclusion of up to $500,000 of gain ($250,000 if filing singly) from income.  To qualify, the home had to be the taxpayer’s principal residence for two out of the last five years.

But what about those folks who also had a vacation home or rental property in some tropical location?  Those properties wouldn’t qualify for the exclusion, so those taxpayers would still get hit with a huge tax liability.  Or would they?

It turned out with a little planning, it was possible to sell the primary home, move into the rental home for a couple years (thus transforming it into the primary residence), sell the second home – et voilá: a cool million dollars in gain, tax-free.

Now that loophole has been all but eliminated, as the amount of gain recognized on home sales must be allocated between the time the house was used as a personal residence and the time (beginning in 2009) it was used otherwise. In addition, you still have to meet the two years out of five test.

Let’s say you purchased that vacation/rental home in 2002, with the plan that it would become your primary residence in 2010.  Under the old rules, you could live there for two years, sell it in 2012, and exclude all of the gain from taxable income, up to the $500,000 limit.

Under the new rules, however, you would have one year of non personal residence  use (2009) out of a total of 10 years of ownership.  As a result, 10 percent of the gain would not be excludable under the personal residence exemption.

Taxpayers who have made planning decisions based on the old gain exclusion rules should contact their tax advisor to determine what, if any, changes should be made to their plan.