Prior to the tax law change, you could purchase a vacation home or rental property years before you retired. Once you retired, you could sell your principal residence. As long as you lived in that home for two of the last five years before selling, you could then sell the home and exclude up to $250,000 of gain if you are single and up to $500,000 of gain if you are married filing jointly. After that, you could move into your vacation home and use it as your principal residence. Then, as long as you had lived in the vacation home at least two of the last five years before selling, you could sell that home and exclude the gain up to the limits noted above.

The new law now separates holding periods into qualified and nonqualified use. When a home is sold, the gain must be allocated between qualified and nonqualified use, with the portion of the gain related to nonqualified use included in taxable income.

The law is effective after December 31, 2008. Qualified holding periods include:

• Holding periods prior to January 1, 2009;

• Holding periods after January 1, 2009, where the taxpayer uses the residence as his/her principal residence; and

• Any portion of the five-year period after the taxpayer's use of the property as a principal residence, provided the home is sold within that five-year period.

To count as qualified use, the home must be used as the principal residence by the taxpayer, the taxpayer's spouse, or the taxpayer's former spouse. A temporary absence from the home for reasons of employment, health, or unforeseen circumstances not exceeding two years does not count as nonqualified use. Any period up to 10 years that the taxpayer or the taxpayer's spouse is serving on extended military duty also does not count as nonqualified use.

Now, when a principal residence with nonqualified use is sold, even if the home has served as the principal residence for two of the last five years preceding the sale, any gain must be allocated between qualified and nonqualified use. Gains related to nonqualified use must be included in income, taxable at capital gains rates as long as the home was held over one year.

Thus, starting in 2009, there is no tax benefit to taxpayers to purchase a vacation home that will later be converted to a principal residence. For those who already own vacation homes, the longer the pre-2009 holding period and the sooner the vacation home is converted to a principal residence, the better for the taxpayer.