new IRS rule on selling ex-vacation home

I understand the IRS has tightened the rules on sale of former vacation homes. It used to be that my wife and I could sell our primary home and use the $500,000 basis-increase forgiveness, live in our long-held second home for two years as sell that under the same $500,000-profit forgiveness. I hear there now needs to be some calculation that limits the forgiveness in relation to how long the house was owned as a second home. I can't find anything by googling. Help!

Hamsmith,

It is Congress that changed this law and it was signed by President Bush on July 30, 2008. You have the basic idea correct.

You want to look at IRS Pub 523, Selling Your Home. I see this pub has yet to be updated for 2008 tax returns. Here is a link to the 2007 version: http://www.irs.gov/pub/irs-pdf/p523.pdf

The law restricts the exclusion of profit for periods of "unqualified use" after December 31, 2008. If you use your vacation home as your primary residence starting January 1, 2009 you will be able to exclude from income profits from the sale of your home up to the $250,000 ($500,000 MFJ) limit. You must own and use the home as your primary residence for at least 24 months in the 60 months prior to the sale.

Unqualified use is defined as time you do not use the home as your primary residence.
Unqualified use prior to January 1, 2009 does not count.
Unqualified use after you stop using the home as your primary residence does not count.

Starting January 1, 2009, unqualifed use vs the entire time you owned the property will determine the amount of profit that can not be excluded from your income.

If you have taken depreciation on the vacation home, depreciation is taken out of your profit first.

Kiplinger's has this from their June 2008 issue, but it does not cover converting a vacation home to primary residence under this newer restriction: http://www.kiplinger.com/features/archives/2007/01/sellinghome.html