Executive Summary
The exclusion of up to $500,000 of capital gains on the sale of a primary residence under IRC Section 121 is one of the most generous tax preferences available under the tax code, due in no small part to the fact that most people only have occasion to sell their home and harvest such gains a few times in a lifetime.
However, for those who also invest in rental real estate, the capital gains exclusion on the sale of a primary residence creates an appealing tax planning opportunity – to convert rental real estate into a primary residence, in an effort to take advantage of the capital gains exclusion to shelter all of the cumulative gains associated with the real estate. And since the Section 121 exclusion can be used as often as once every 2 years, the planning opportunity is quite significant for those with large rental real estate holdings (or simply those who serially purchase new primary residences!).
To prevent abuse of this planning scenario, Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “nonqualifying” use. Nonetheless, some opportunities remain for real estate investors who do have the flexibility to change their primary residence in an effort to shelter capital gains on long-standing real estate properties.
Rules For Excluding Gain On Sale Of Residence
The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner is allowed to exclude up to $250,000 of gain on the sale of a primary residence (or up to $500,000 for a married couple filing jointly). In order to qualify, the homeowner(s) must own and also use the home as a primary residence for at least 2 of the past 5 years. In the case of a married couple, the requirement is satisfied as long as either spouse owns the property, though both must use it as a primary residence to qualify for the full $500,000 joint exclusion.
Notably, the use does not have to be the final 2 years, just any of the past 2-in-5 years that the property was owned. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). The fact that it was no longer the primary residence at the time of sale is permissible, as long as the 2-of-5 rule is otherwise met.
If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. In such scenarios, a pro-rata amount of the exclusion is available; for instance, if an individual had to sell the home after 18 months instead of the usual 24, the available exclusion would be 18/24ths multiplied by the $250,000 maximum exclusion, which would provide a $187,500 maximum exclusion (which will likely still be more than enough, as it’s unlikely that the gain would be more than this amount unless it was an extremely large house!).
To the extent that a property is highly appreciated, and there is a gain in excess of the available exclusion. The gain will be subject to the usual capital gains brackets, including the new top 20% rate and the new 3.8% Medicare surtax, if total income is high enough for the capital gain to fall across the applicable thresholds.
Example 1. Max and Jenny, a married couple, bought a home decades ago for $250,000, and are now selling it for $900,000. Their total gain is $650,000, and they have easily met the 2-of-5 ownership-and-use requirement. As a result, they can exclude $500,000 of the capital gains. The remaining $150,000 capital gain – eligible for long-term capital gains treatment, as the holding period is far beyond the 12-month requirement – will be reported on their tax return as a normal long-term capital gain, subject to the usual tax rates (and potential 3.8% investment income surtax) that may apply.
Notably, the capital gains exclusion is only allowed once every 2 years. However, if an exception applies that would allow a partial exclusion, the partial exclusion can be claimed even if another exclusion had been claimed for another sale in the past 24 months. Though in the event of a married couple, even the full $500,000 exclusion is only available as long as neither spouse has used it in the past 2 years (if one spouse sold a home recently and the other did not, the second spouse can still use his/her individual $250,000 exclusion). On the other hand, as long as “no more than once every 2 years” requirement is met, there is no limit on home many times an individual can take advantage of the primary residence capital gains exclusion throughout their lifetime (in 2-year intervals)!
Converting A Rental Property Into A Primary Residence
For most people, the exclusion of capital gains on the sale of a primary residence is something that only comes along a few times throughout their lifetime, as individuals and couples move from one home to the next as they pass through the stages of life. However, because the exclusion is available as often as once every 2 years, some homeowners may even try to sell and move and upgrade homes more frequently, to continue to “chain together” sequential capital gains exclusions on progressively larger homes (presuming, of course, that the real estate prices continue to rise in the first place!). However, in some cases taxpayers decided to go even further, taking long-standing rental property, moving into it as a primary residence for 2 years, and then trying to exclude all of the cumulative gains from the real estate (up to the $250,000/$500,000 limits), even though most of the gain had actually accrued prior to the property’s use as a primary residence! The opportunity is especially appealing in the context of rental real estate, as the potential capital gains exposure is often very large, due to the ongoing deductions for depreciation of the property’s cost basis that are taken along the way.
The limit this technique, Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first, created as part of the original rule under IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation recapture will still be taxed (at a maximum rate of 25%).
Example 2a. Harold has a property in 2009 that was purchased for $200,000 and is now worth $350,000. It was rented for a period of years (during which $29,000 of depreciation deductions were taken), and last year Harold moved into the property as a primary residence. The current cost basis is now $171,000 (after depreciation deductions), which means the total potential capital gain is $179,000. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion.
In addition to the limitation of Section 121 regarding depreciation recapture, as a part of the Housing Assistance Tax Act of 2008, Congress further limited the exclusion of capital gains for property that was converted from a rental to a primary residence. The new rules, enshrined in IRC Section 121(b)(4), stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence; any other time (since January 1st, 2009) that the property was not used as a primary residence is deemed “nonqualifying use”. Accordingly, to the extent gains are allocable to periods of nonqualifying use (gains are assumed to be pro-rata over the holding period), those gains are not eligible for the exclusion.
Example 2b. Continuing the earlier example, if Harold had actually rented out the property for four years (2009, 2010, 2011, and 2012) and then used it as a primary residence for two years (2013 and 2014) to qualify for the capital gains exclusion, and sell it next year (after meeting the 2-year use test), the total $150,000 of capital gains (above the original cost) must be allocated between these periods of qualifying and non-qualifying use. Since there are only 2 years of qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). As a result of these limitations, the remaining $100,000 of capital gains attributable to nonqualifying use will be subject to long-term capital gains tax rates (along with the $29,000 of depreciation recapture).
Example 2c. Assume instead that Harold had purchased the property not in 2009, but in 2000, and rented it for 13 years (from 2000 to 2012, inclusive) before moving into the property in early 2013 to live there for 2 years, with a plan to sell in 2015 and maximize the Section 121 capital gains exclusion. Because only nonqualifying use since 2009 counts under IRC Section 121(b)(4), Harold will be deemed to have 4 years of non-qualifying use (2009, 2010, 2011, and 2012), and 11 years of qualifying use (2000-2008 inclusive, and 2013-2014). As a result, 11/15ths of gains, or $110,000, would be qualifying gains eligible to be excluded (and since that’s less than the $250,000 maximum exclusion amount, it would all be excluded), while only 4/15ths of the gains, or $40,000, would be nonqualifying and subject to capital gains taxes. In addition, any depreciation recapture since 2000 would still be taxed as well.
Converting Rental Property Into A Primary Residence After A 1031 Exchange
Notably, an additional “anti-abuse” rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange – for instance, in a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!). To limit this, American Jobs Creation Act of 2004 (Section 840) introduced a new requirement (now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.
Example 2d. Continuing the prior example, assume that Harold’s original ownership since 2000 was of an apartment building, and in early 2011 he had completed a 1031 exchange to a single family home, with the ultimate intention of moving into the property as a primary residence to claim the capital gains exclusion. Even if Harold moves into the property in early 2013 and lives there for 2 years, he will not be eligible for any capital gains exclusion until 2016 (five years after the 1031 exchange). At that time, he can complete the sale and be eligible for the exclusion. He will still have 4 years of nonqualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use (2000-2008 inclusive, and 2013-2016), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed nonqualifying use capital gains and subject to taxes (in addition to any depreciation recapture).
Fortunately, while the rules do limit the exclusion of capital gains attributable to periods of nonqualifying use (after 2009) in the case of a rental property converted to a primary residence, the rules are more flexible in the other direction, where a primary residence is converted into a rental property. IRC section 121(b)(4)(C)(ii)(I) allows taxpayers to ignore any nonqualifying use that occurs after the last date the property was used as a primary residence, though the 2-of-5 ownership-and-use tests must still be satisfied.
Example 3. Donna has lived in her property as a primary residence since 2008. In 2012, she received a new job opportunity across the country, but decided she didn’t want to sell the property yet as home values were still recovering in her area, so she rented the property instead. Now, in 2014, as home prices have continued to appreciate, she wishes to sell the property. Even though there have been 2 years of otherwise-nonqualifying-use as a rental, Donna does not have to count nonqualifying use that occurred after she lived in the property as a primary residence. As a result, all gains will be treated as qualifying, and eligible for the capital gains exclusion (except to the extent of any depreciation recapture). Even though Donna does not still live in the house as a primary residence, she has still used it as a primary residence in at least 2 of the past 5 years (as she lived there in 2010 and 2011 before renting in 2012), so the Section 121 exclusion is available. However, it’s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test.
In the above example, if Donna had chosen to subsequently exchange her converted rental property to a new one under IRC Section 1031, additional rules apply under IRC Section 2005-14 to properly allocate gains between Section 121 exclusion and Section 1031 deferral.
Planning Implications Of Section 121 Primary Residence Gain Exclusions
Arguably the Section 121 exclusion of capital gains on the sale of a primary residence is one of the most favorable tax preferences under the Internal Revenue Code, given both the sheer magnitude of the gains that can be excluded, and the fact that there is no limit to how many times it can be taken (beyond the limit of no more than once every 2 years).
Of course, from a practical perspective, many (most?) individuals and couples treat their home as a home, and not as an ongoing chain of serial real estate investments from which tax-free capital gains can be harvested as long as they live in it for at least 2 years first (which in reality is why Congress allows such favorable provisions in the first place). While a few clients might actually be inclined to move repeatedly from one property to the next – taking advantage of the capital gains exclusion every time gains approach the maximum exclusion amount – this will not likely be a popular strategy for most.
However, given that most clients will probably only have an opportunity to take advantage of these rules a couple of times throughout a lifetime, it becomes all the more important to properly plan in the first place to ensure the exclusion will be available. This may include having clear documentation to show exactly when the property was used as a primary residence (especially if it may not be the full 2-year period and the pro-rata partial exclusion may apply, or if there are periods of qualifying and nonqualifying use), and also planning around using the exclusion in the event of death or divorce of a spouse (in both situations, ownership and use of a deceased spouse or an ex-spouse can potentially be ‘tacked on’ to the subsequent owner to qualify for the exclusion). In the case of newly married couples, this may include additional coordination if either (or especially if both) previously owned a primary residence, and wish to sequence their sales to allow the maximal exclusion (for instance, one spouse sells one property for a $250,000 exclusion, both move into the other property for 2 years, and then the couple sells the second property for a $500,000 exclusion).
For clients that are more active real estate investors, there may be significant appeal to more proactively taking advantage of the primary residence exclusion rules, notwithstanding the limitations on nonqualifying use, especially in light of the fact that gain is always assumed to be allocated pro-rata across all the years, and not necessarily based on when gains actually occurred. This effectively creates an incentive for property that has rapidly appreciated during its rental period to be converted into a primary residence, even if the appreciation rate will slow.
Example 4. Donald purchased a rental property in early 2009 at the market bottom for $400,000, and it has appreciated in the 5 years since to $750,000. If Donald sells his current house, and moves into the rental property now to make it a new primary residence and sells it in 2 years for $775,000, the total gains above original cost will be $375,000. Since Donald will have 2/7 years of qualifying use, he will be eligible to exclude 2/7 * $375,000 = $107,143 of capital gains, even though the actual gains during his time living in the property were only $25,000. In addition, Donald will have been able to benefit from the capital gains exclusion on his prior home (sold 2 years ago), and the capital gains exclusion again on this rental-property-converted-to-primary-home, as long as the sales are at least 2 years apart. (Alternatively, if Donald had not sold his prior residence, he could have simply held it throughout, and then moved back into the original property and continued its use as a primary residence, though there would now be 2 intervening years of nonqualifying use for that property.)
Given that nonqualfiying use only counts for such use since 2009, real estate investors may find it most appealing to move into older rental real estate properties, that have a significant amount of gains that can be allocated prior to 2009 (where even though it was rental property, it doesn’t count as nonqualifying use). The qualifying/nonqualifying use rules will make the strategy less appealing for most real estate investors on a forward-looking basis, though planning opportunities remain in the aforementioned scenarios where rapid appreciation during nonqualifying use periods can be sheltered by subsequent qualifying use when there is slower growth (effectively shifting income from the less favorable time period to the more-tax-favored one).
In the case of properties that have been converted from a primary residence into rental real estate, the key planning issue is to recognize that there is a limited time window when a property can be rental real estate but still be eligible for the Section 121 exclusion – eventually, the property is rental real estate so long, the owner will no longer meet the 2-of-5 use-as-a-primary-residence test. For instance, in the earlier Example 3, Donna can only rent the property for up to 3 years after living there as a primary residence, before she can sell it and claim the Section 121 exclusion (or risk moving beyond the 2-of-5 years time window).
The bottom line, though, is simply this: for those who are more flexible about their primary residence living arrangements, and move more frequently (or are often forced to do so by job/life circumstances) there are significant tax planning opportunities available thanks to the Section 121 capital gains exclusion on a primary residence. For clients who are more active real estate investors, and have the flexibility to convert rental properties into primary residences, additional opportunities apply to navigate the nonqualifying use rules (and/or simply recognize that pre-2009 rental use won’t be counted against the owner as nonqualifying use in the first place!). However, because of the stringency of the rules – and the magnitude of the capital gains taxes that may be due if a mistake is made – it’s crucial to follow the rules appropriately to gain the maximum benefit (or any benefit at all!)!
To make things more complex, some people also built a 2nd living space (i.e., a guest house or a fully converted garage) and rented it out. Does it also impact the applicable exemption amount? I read something a while. Apparently, if the extra unit is attached to the main house, then the owner could disregard it. However, it will be a different case if the unit is a stand alone one sharing the same lot.
Thanks Michael. As always, very helpful.
Thank you for an excellent explanation. But what if a property started as a primary residence, then became a rental, then the owner moved back for 2 years to make it primary. For example, if a property was purchased in 1992 for $115,000 and the owner lived there until 1997. Then rented from 1997 through 2014. Then moved back for 2 years (2015, 2016). Then sold it for $415,000 in 2017. Would the $300,000 Capital Gain be excluded because the property was converted as a primary residence into rental real estate in 1997, even though it was rented from 1998 through 2014, and then moved back in to meet the 2 year rule?
MSA,
If your example, there would be 6 nonqualifying years (2009, 2010, 2011, 2012, 2013, and 2014). All of those years of nonqualifying use would count. You can only exclude nonqualifying use BEFORE 2009 (when the rules didn’t apply yet), or nonqualifying use AFTER THE LAST DATE the property is used as a residence (and since the property is used as a residence in 2015 and 2016, you can’t ignore any of the prior nonqualifying use).
Given that the property would be owned for approximately 25 years (from 1992 to 2017), and there are 6 years of nonqualifying use, then 6/25ths of the gain would be nonqualifying, and the other 19/25ths of the gain would be eligible for the $250,000/$500,000 capital gains exclusion.
– Michael
Michael Kitces,
MSA said that it used this property as a primary residence from 1992-1997 and only then converted in into a rental unit. It seems that there is NO nonqualifying use since this property was FIRST used as a primary residence and only then converted to a rental. If MSA moved in to make it a primary residence in 2015-2015 in order to satisfy the 2-out-of-5 years as primary residence test then wouldn’t the entire gain upto the maximum limit $250,000/$500,000 be sheltered from long term capital gains tax?
Hi Michael,
could you please helping me with this question.
I have a condominium that I purchased on 2002 and I leave there as my primary residence for 5 years and 2007 my son purchased a home and I moved with him and the condominium was renter as today can I sold the condominium as primary residence due to I leave there for the first 5 years went I purchased it ?
if I sold the condominium maybe my gain will be only 10,000 thousand because is no equity.
I am curious about this response too. @Michael_Kitces:disqus
Lets say a couple has property A is purchased in 2010. lived in for 3 years as their principal residency. they move to another state for 7 years and decide to rent out their house. They move back to property A, their former principle residence, and live there for 4 more years, and then they decide to sell. there are 7 years used as a rental, but it was originally purchased and used as a primary/principal residence, and when sold, was a primary for more than 2 years. Are those 7 years excluded based on the fact that it was originally a primary residence?
—- essentially, if when an owner possesses a property, and its first use during ownership is as a principal residence, rent it, come back years later and turn it into a primary again for 2 years before selling it, can they exclude the nonqualifying use periods that occur between the initial and final periods of principal use?
Another way, Will sandwiching the rental use between the very first use and last use of the property being a primary rental longer than a 5 year period allow for still fully being able to use the gain exclusion of section 121 without needing the prorata rule?
See my question to Michael below
My wife and I purchased a home (home x) as our personal residence in 1977 for 39k. 1981 purchased another home as personal residence converting X to rental and has been rental since ’81. Now retired and will be moving back into X. After two years of occupancy will we be eligible for the exclusion of gain? Do the rules enacted in 2009 apply since this was originally purchased as personal residence? X is now worth about 400k. We have not used the personal residence sale exclusion at on any prior sale as subsequent homes were sold at a “loss” or no gain (short sale) Any thoughts, suggestions?
I have a second home consider primary for 4 months (April, 2013), I will renting it out for 2 years, plan to live there for 2 years. Could I claim exclusion?
Michael,
I just sold a lot I owned for 25 years. I had no depreciation taken, because it was a lot.
The basis is $100,000, and the net sale proceeds were $415,000, for a $315,000 gain.
I just 1031ed (is that a word) the $415,000 into a $475,000 rental house, adding $60,000 cash, which closed September 1 2014.
I will rent the house for three years, and then my wife and I will move in for the two years remaining for the 5 year period and then sell the house. (As I understand it, I could move there for the last four of the five years to pick up two more qualifying years – is this correct? But I am not yet ready to move into it
Since the lot was an investment property, but not a rental, for the 25 years, does this mean the entire time up to the 1031 is qualifying time?
Assuming we sold the house for $650,000 in September 2019, what would our capital gains tax look like?
A few questions, I know, but your input would be helpful to us and those like us.
Doug
Hello and thank you for your very helpful responses at this site!
I have a question regarding the Housing Assistance Tax Act of 2008 and how it may impact my Capital Gains exclusion upon sale of my property.
My wife and I owned and lived in our home from 2003 to 2013 as our primary residence. In November 2013, I moved for work and we converted our home to a rental. If I continue to rent the home and then sell prior to November 2016, will we still qualify for $500k in capital gains exclusion (because we lived in the home 2 of the prior 5 years preceding the date of sale), or will we have to pay capital gains on a % of our gains because of the Housing Assistance Tax Act of 2008 (since the property was used as a rental subsequent to Jan 2009)?
Thank you!
Dave,
Per the article and discussion of IRC section 121(b)(4)(C)(ii)(I), when it’s a primary residence first and converted to rental property second, nonqualifying use AFTER it was a primary residence is not considered as long as the property is otherwise still sold in time for the 2-out-of-5-years test.
So yes, as long as you sell the property by November of 2013, all of the gain will be qualifying use, and all of the gain will be eligible for the $500k capital gains exclusion. (Though any depreciation will still be subject to recapture gain.)
– Michael
I bought a house as my primary residence in April 2013 and had to move, so rented it out November 2014-15 (lease ends nov) so 1 year and 7 months. I’m putting it back on the market. Do I get partial credit? My gains will be around 25k… I planned to move back in after the lease with my now ex boyfriend who was convicted of assault and battery against me, so I had to move far away…I haven’t owned the property 5 years and lived in it less than 2, rented 1 just as a recap.
Thank you Michael. This is the best article on this subject I have come across to date.
Thanks for the article. Very informative. my question is the following. I one of my properties for 2 years. Then renovated it and moved into it this year. I understand I can no longer take the depreciation deduction for the value of the house. Does this apply to everything else? I was amortizing closing costs and points. If i can’t take those deductions in full, would i take them for the 2 months the house was rented in 2014? Final question, I have a losses from 2013 i was not able to fully deduct due to passive loss rule. I was going to carry that into 2014. Can I take that loss or because the house is no longer a rental I can’t? Thanks in advance for your help!
My wife and I own a Duplex that we built in 1993. The property was built for $260,000. One unit was rented throughout, the other never was. 7 years as our primary residence and the balance as a home for our daughter, no rent was ever charged. I have taken 1/2 of the total cost and took depreciation for all years but no depreciation on the other unit. We are considering establishing the unit that has never been rented as our primary residence. I assume that at sale our cost basis for that unit will be $130,000 and subject to the max $500,000 tax free. Is the rental unit to be treated as simply a Capital Gains event after depreciation recapture
I bought my house in 2009 for $1.3M and used it as a primary residence through 2014. It is worth about $1.7M now but I would like to rent it for 2 years ($10K a month) and then sell it.(I hope of $2M in two years.)
What are the benefits of selling now or waiting the two years?
Property was purchased in 1973. It was rented for about 27 years.Then it was exchanged for 2 properties in 2009. One was rented for 4 years and then became a vacation home. One is still rented. Now, we are thinking of making the vacation home a primary residence for 3 years then selling it. In this situation, what kind of capital gains taxes would be due, assuming sales price is $325,000 with no basis. And what about if it converts from 4 years rental, to say 3 years primary, to one year rental. Will that lessen capital gains due?
I personally own a property that was a business rental property. I moved into the property and have used the second floor as my principal residence for the last 2 years. There is no separate entrance for the upstairs. I believe I do not have to allocate any of the gain and will only have to pay tax on the recapture. Can I get your take on this? I am reading Publication 523 and it states:
Property Used Partly for Business or Rental:
If you use property partly as a home and partly for business or to produce rental income, the treatment of any gain on the sale depends partly on whether the business or rental part of the property is part of your home or separate from it.
Part of Home Used for Business or Rental:
If the part of your property used for business or to produce rental income is within your home, such as a room used as a home office for a business, you do not need to allocate gain on the sale of the property between the business part of the property and the part used as a home. In addition, you do not need to report the sale of the business or rental part on Form 4797. This is true whether or not you were entitled to claim any depreciation. However, you cannot exclude the part of any gain equal to any depreciation allowed or allowable after May 6, 1997. See Depreciation after May 6, 1997, earlier.
On your June 4 2014 newsletter , example 2d. Does this apply to an LLC. If an LLC owns the property and a 99% owner of the LLC converts the property into a primary residence. Will Example 2d still apply.
Very informative article; wish I had seen this back in 2009. Here’s my question: I am looking to sell my principal residence this year and am also considering doing a 1031 exchange on an investment property in the same time period. I am aware of the 2 year rule for the exclusion of gains on a principal residence. Will selling both my investment property (thru a 1031 exchange) and my principal residence in the same year have any impact on my qualification for the exclusion of gains on my principal residence? Are there any other factors regarding taxation that I should be aware of if I do both sales within the same year?
I am about to purchase an investment property which will be converted to our primary residence in 5 – 10 years.
The question I have is how depreciation will impact our taxes 5 – 10 years from now when we move in. Also, is there some particular way we should be filing taxes for the next 5 – 10 years to minimize the tax impact?
Wonderful article, thanks! I’m working hard with my limited knowledge to understand it to apply it to my situation: Purchased duplex @ 65K in 1996 and lived in half then moved and rented both units until sold @ 175K via 1031 exchange completed Aug 2002 for SFH @ 180K. SFH has been rented 100% of the time since then and is assessed at $236K. I’m considering the financial pros and cons of doing another 1031 exchange vs. moving in myself June 2015 and selling June 2017 @ maybe 275-300K with some upgrades (kitchen/baths) and would love your feedback!
When you say non-qualifying use , do you mean any use of the property other than primary residence, the confusion is regarding repeated mention of rental property. Rental Property is treated much differently according to the IRS, then say a mortgage interest deduction for two homes that are not rental properties in other words personal use.
What happens if one spouse has the homes as a primary residence and other doesn’t. Although you would have to file taxes jointly to qualify, there is no requirement for both spouses to live in the same home for the last 2 out of 5 years although you will still have to wait 2 years before again taking the exclusion, would this be advised for properties of personal use.
Alex,
Per the article (and under the tax code), non-qualifying use is defined as any time (since January 1st, 2009) that the property was NOT used as a primary residence. It doesn’t matter what you did with it; it just matters that it was NOT used as a PRIMARY residence.
If only one spouse meets the “use” test as a primary residence, the couple will be limited to a $250,000 exclusion. In order to qualify for the full $500,000 exclusion, BOTH spouses must meet the use test (though notably, EITHER spouse can meet the ownership test, so the property doesn’t have to be jointly owned).
– Michael
Also, are the rules different for instance, Sally and Bill has Home A and Home B, Home A is either Sally’s or Bill’s PR (primary residence), they both file a joint tax return.
Let’s suppose they bought Home B and owned it for several years as a second home in a vacation area or say Florida, after several years of owning the home as a non-qualified residence basically non-pr
(I won’t get into the details of saying its a rental vs. a second home with a mortgage since there are depreciation and other rules but feel free to elaborate if it matters).
So they decide as many folks do to sell Home A and take the exclusion. They move into Home B and now that property values are on the rise they won’t to downsize and move to a smaller property. However, they realize they don’t be able to take the full capital gains exclusion as it would be pro-rated between non-qualified vs. qualified PR use.
Suppose however they go ahead and buy a condo, which I will list as Home C 2 years later, they then decided to retain Home B (either rent it or use it as second home on occassion and deduct mortgage interests).
Family and Friends come over to visit often and eventually their mother-in-law decides to move in with them, since House C, a condo, is small, they move back into Home B and its the PR. The mother-in-law goes into a nursing home two years later (Feel free to insert what years matter), They rent the Home B or leave it vacant again for 2 years, and go back the condo, Home C which was being rented or left vacant while they were in Home B.
My understanding is a period of non-pr or non qualified use is pro-rated but what happens in this situation, my understanding is that non-pr cannot be followed by PR to claim the non-pro-rated exclusion, but that PR can follow non-PR, I am not sure what happens if things alternate as how they moved into Condo C and then back again. Can they claim the full non-prorated capital gains exclusion of $500,000. My previous question of course indicated that what happens if one spouse has one PR and the other another PR which is not the case here.
Alex,
You can still have nonqualifying use (“non-PR” in your terms) occur after qualifying use as a residence. The tax code allows you to exclude the LAST segment of non-qualifying use after the LAST use as a primary residence (assuming you’re still otherwise within the 2-out-of-5 requirement to be eligible for the capital gains exclusion at all).
So if you alternative 3, or 5, or 7, or however many instances of non-qualifying and qualifying use, the LAST non-qualifying after the LAST qualifying segment doesn’t have to be part of the calculation of non-qualifying use. All the OTHER non-qualifying use periods will still be counted as non-qualifying use when calculating how much in capital gains can be excluded.
– Michael
I purchased a condo in 2007. I rented the condo for 6 years. I have now lived in the condo for a little over two years as my personal residence. Is there any other way to meet the five-year requirement to avoid capital games if I don’t continue to live in this house. For instance, is it possible to do another exchange and continue to defer capital games as I’m living in the second property as my personal residence? In other words can I combine the amount of time spent as a rental and the amount time spent as a personal property amongst two properties the current property and a new property?
Alex,
We purchased a SFR in 1990, lived in it as our primary residence until April 2005. Rented it from April, 2005 through 2015 and are going to make it our primary residence starting in 2016. We plan on living their for 2 or 3 years and then selling it. Assuming the laws do not change would the qualifying years be 1990 – 2009 and 2016 – 2018 and the non-qualifying years be 2009 to 2015?
Michael,
If we convert a rental property into our primary residence and two years later sale the home. When do we have to recapture the depreciation? In the year we convert to a primary residence or when we sell the home?
Depreciation recapture occurs at the time of sale.
When you convert into a primary residence, you’ll simply stop claiming ADDITIONAL depreciation at that point.
– Michael
Thank you, Michael
Michael,
Excellent article – thank you! Regarding to Example 3, “..However, it’s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test.”… Can’t Donna take Partial Exclusion IRC 121(c)(2)(B) since her move was due to change of employment?
Yuki
In the conversion does the 2 year occupancy have to be contiguous or can you rent for periods less than 6 months and still take partial credit toward the 2 of 5 year requirement. Meeting the 2 year requirement over approximately four years.
We are in an unique situation in that we have a home that we would not get capital gains on it as it is so custom, it would not sell for what we built it for. Built for around 4.5 million there are very few people who could afford the home and so if we sold it we would take a significant loss. We would like to turn this into a short term vacation rental. We have several rentals and are comfortable in renting it. Three questions. 1) For tax purposes, can we prorate all expenses including depreciation for the time it would be a rental. 2) In a future year, if we take it back as a personal residence, and sold the home, how would the depreciation be treated in carrying losses over to future years. 3) so could we benefit with the rental with the deductions, especially depreciation, to benefit us now, carry those losses over and then move back in the two years before we sold and have the capital gains exemption is sold higher than the cost basis.
Michael, this is an excellent article–by far the best explanation and examples I’ve seen on this topic. With that said, I still have some questions that apply to my personal situation. I hope you will indulge me.
My wife and I own a townhouse, which we bought in 1999. We lived there as our primary residence for 18 months, then converted it to a rental property when we moved away from the area. (I was, and remain, an active duty military member.) We continue to rent the property, and now it has appreciated ~$300k over the original purchase price. My question: What is the best exit strategy if we want to eventually use this equity for a primary residence in retirement?
1) Option 1: I may eventually move back to the area, and could convert the townhouse back to a primary residence. However, I don’t want to retire there. I believe if I lived there for 2 yrs and then sold the house, I would at least have to pay taxes on depreciation recapture. However, does the fact that I lived in the house before I first converted it to a rental property mean all of my rental period (2000-present) would be considered qualifying for the capital gains exemption (similar to example 3)? Or just a pro-rated portion?
2) Option 2: Would I be better off to continue using it as a rental property until I find my retirement home in 10+ yrs, then buy that home using a 1301 exchange…use it as a rental property for 1-2 yrs…and then move in as a primary residence? If we did this, and never sold that house, we would pay neither depreciation recapture nor capital gains taxes, correct? Further, what would the tax liabilities be if we went with this strategy but ended up selling the “retirement” home after several years of using it as my primary residence? The same as they would have been in my first scenario?
Or is there a 3rd, and potentially better, option I’m not considering?
Thank you!
I have a dwelling that I lived in for three years, then made it into a rental property for ten years. I moved back into the property lived there for five years and then converted it back to rental for five. I am now selling the property. How do I calculate the capital gains for tax purposes?
Michael… Great article, but I didn’t see an example where one trades out of a long-held investment property (10+ years commercial or residential) into a residential property and immediately moves into it, lives there for 5 or more years. Can he do that and does it qualify for the full 500k tax-free gain if he and wife sell it?
Hi Jack,
I assume that you did a 1031 exchange on the property or that the original investment was a residence. In both cases after 2009 the tax free gain is pro-rated for the time that the property was a residence and the time the property was a investment. The original purchase price of the investment property is used in the calculations. There are a few more details but I think this gets you going the the right directions.
Tax laws are always a moving target. It’s really hard to make long term plans when the laws always change short term.
Michael, great article. It really explains a lot about a complex topic. I bought my house in 1989, lived in it for 2 years, rented it out for 23 years and converted it to a personal residence 1 Jan 2015 planning to live in it at least until 2018 and possibly indefinitely. Although depreciation caused my rental to run at a slight loss due to my day job my MAGI has exceeded the $150K limit for deducting active participation rental real estate losses for most of the past decade so I have a substantial accumulated balance of unallowed loss. I’m unclear how to handle to this. I know that if I had just sold the rental house I could have immediately claimed all of the unallowed loss regardless of MAGI but I’m unclear what happens and whether that depreciation counts towards my eventual capital gain or if it somehow gets factored in and if so how. Thanks for any help.
the article is extremely well written. I have spent 100s of hours learning the details in the past and had to dig through the IRS code – painful. We had planned to take advantage of the loophole that existed by purchasing a rental house and then moving in years later and living there 2 years and taking up to $500,000 in capital gains tax free. As the article says this loophole in the tax code was closed. I did have a friend that made a fortune in San Jose by purchasing 4 houses for under $100,000 and renting them for 20 years and then moving back into each one and living there for 2 years and selling each for $500,000 to over $600,000 before the tax code change effective in 2009. The details on the 1031 exchange was interesting and new to me.
thanks for the article.
Great article! Thank you! I have a question. My fiance and I bought our loft in April of 2015, and currently use it as our primary residence. My fiance took a new job recently that is much farther away, so we are planning to buy a home closer to his place of work in the beginning (Jan-Feb) of 2017. We are planning to keep the loft and rent it out. If we decide to sell the loft any time before 2020, would we be eligible for a partial exclusion since we lived in the loft for 75% of the first two years of ownership before converting it to a rental home?
We purchased a rental 10 years ago using a 1031 exchange. We would like to update date the appliances, central air, carpet,etc.. As our rental property we can depreciate these items over time. What happens to the depreciation if we choose to occupy the rental as our permanent residents.
Expense the remainder, in the final year (up to 25,000), and before converting the use, against any rental income for that property, in that final year.
my client wants to sell all his california rentals and buy a primary residence in florida can he do this in a 1031 exchange
like kind exchanges means the residence in florida would have to be a rental (first) before he would move into it
Hi Mike Kitces,
I bought home in CA in year 2004. I moved to India in the end of year 2008 and living there since then . I lived in my USA home for 4 years. I have been getting rental income on this home since year 2009. I am planning to sell my home in 2 to 3 years by end of year 2018.
I bought the home for $515000 in year 2004. Current market price is more than a million. I spent around $30000 for home improvements in year 2004 itself.
What is the planning that I need to do for getting best tax savings on the gain if I want to sell my home in 2018. I am USA citizen. I have no plans to return to USA for at least for another 5 years.
Thanks in advance …
Regards,
Srinivasa Reddy
Hi Michael,
I would be grateful if you could answer a question regarding the renting requirement after doing a 1031 exchange. The SFR was our primary home which has been rented due to a job relocation. We are in the process of purchasing a replacement property which we want to move in as our new primary home. My question is do we need to rent out the new property (for at least 12 months) before moving in as our primary home (since the relinquished property originally was our primary home).
Much appreciated for any advise!
How long did you rent out your primary residence, is the question … did you file multiple years of taxes SchE with the previous principle residence as a ‘rental property’ ? I would consult a tax advisor, it seems if you lived in the property for 2 of the past 5 years, you might still treat it as your primary residence for tax purposes and have no issue moving into the new property. In other words, why do the 1031 exchange (if you indeed lived there 2 of the past 5 years), now if its been more than 4 years ago … then you might have to abide by 12 mos. rule … although that maybe be soft, as if you cannot rent it at the price you want, and moved in in 3-4 mos. the IRS has been ‘grey’ in those areas … they need to see ‘intent’ to establish it as a replacement rental property. Sometimes best intentions do not come true … you wanted to rent it for 3K/mos. and there were no takers. So you moved in. Keep proof of advertising, and honest attempts to use it for its intended purposes in case of audit.
I have a rental condo for 25 years. I would like to sell it and buy my mom home when passes. How can I sell the condo and avoid taxes and buy my mom’s house and keep her low property taxes (I’m in California).
If i convert my primary residence to rental property for purposes of doing a 1031 exchange after two years of rental, and then sell at a point when 2.5 years of last five wold be primary residence, can I still get the $500K exclusion? Is the exclusion about reduced in some manner by the rental period?
We’ll be speaking to an attorney, but until then we’re wondering if we qualify for the 2/5 rule: My husband and I bought a house in 2010 and lived there until 2014 when my husband was offered a job out of state. We didn’t want to sell right away, so we rented our house starting 2/2014. Our tenants are buying a house so we have put it on the market. They will be completely out by the end of the year, so last rent will be 12/2016. If the house sells after 2/2017 we won’t make the 2/5 rule or would we? If we aren’t using it as a rental in 2017 because it’s on the market, will it be considered unqualified? We won’t be living there and we won’t be renting it. When we file taxes for 2017 we aren’t going to claim any rental income (as there won’t be any) or depreciation because we’re selling it. (Rental income/depreciation was claimed on tax years 2014-2016).
Hi Tara: did you get an answer to your question? I am in a similar situation, bought a house 3 years ago, lived in it for 2.5 years, turn it into rental for 1 year and will try to sell it. Would this qualify for the capital gains exemption under 2/5? thanks
Mr. Kitces,
When converting a rental into a primary residence does the IRS require any special notification? Do we just move in and start using the rental’s address as our primary address and stop reporting income from the rental?
Hello Mr. Kitces,
Great article. Thank you! Question: My 89 year old mother bought a home in one county in California in the 80’s, lived in it until 2003, and then moved to a rented retirement community in another county. If she sells her prior home (now investment property), does a 1031 Exchange, and buys an investment property in the new county, how long must she wait to move into the newly purchased home and make it her primary residence?
Just wanting to know HOW (paperwork necessary) to convert my income property back into my primary residence and if there’s a time qualifier after that in which I have to keep it. If anyone can Keep It Super Simple for me I’d appreciate it. I don’t really get all the flip it and score jargon for selling. I want to live in it but don’t know if there’s some tax implications that will prevent it. Thanks!
Great article. Thank you. I have a question regarding inheritance of a rental/primary residence. My parents bought a condo in 1978 for investment purposes for about $108K. Current value is about $430K. It was a rental until mid-2016 when my widowed mom moved in. Needless to say, the condo was fully depreciated. It’s my mom’s intention to stay in this condo until she passes. My sister & I will inherit the property. If the value is $430K when we inherit, what will our tax basis be for the property?
I believe with a ‘stepped-up’ basis and if the property title is structured (like in a trust) to automatically transfer on death, and avoid probate, ends up being the $430K (or the value at the time of death/transfer) … the key is to set up the asset to transfer, see family trust revocable or irrevocable and consult an estate attorney to establish and put title in correctly, the trust’s name.
Thank you for your response. I’ll follow through with my mom and sister.
I just sold our primary residence in Oshawa and we will be moving into our new residence in September. We also purchased a townhouse near UOIT ,this residence has been occupied for almost a full year by my daughter .. Can that property be considered a primary residence and can we sell it the same year if she lived in it for a full year with no tax implication? or must we wait for the second year before selling it ? If it can be sold the same year as my other property can it be listed before the year end and can the closing be at the 1 year mark?or must we list it on the market at the 1 year mark of my daughter occupying it ?
Michael,
It’s been a few years since you wrote this article. Is the outcome that you describe for Example 3 of your article still true today? I copied and pasted it below. I’d be in a similar situation as in that example. thank you,
Alex
“Example 3. Donna has lived in her property as a primary residence since 2008. In 2012, she received a new job opportunity across the country, but decided she didn’t want to sell the property yet as home values were still recovering in her area, so she rented the property instead. Now, in 2014, as home prices have continued to appreciate, she wishes to sell the property. Even though there have been 2 years of otherwise-nonqualifying-use as a rental, Donna does not have to count nonqualifying use that occurred after she lived in the property as a primary residence. As a result, all gains will be treated as qualifying, and eligible for the capital gains exclusion (except to the extent of any depreciation recapture). Even though Donna does not still live in the house as a primary residence, she has still used it as a primary residence in at least 2 of the past 5 years (as she lived there in 2010 and 2011 before renting in 2012), so the Section 121 exclusion is available. However, it’s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test.”
Is the gain required to be prorate or is it a rebuttable presumption? In our case, the rental property was severely damaged during Hurricane Matthew. It needs more than $200,000 of repairs. If we move in now, can’t we show that the value is at least $200,000 lower than it was before the hurricane?
At least some of the “repairs” that add to the value of the home and prolong its useful life would be treated as additions to your cost basis, which reduces your gain. General repairs are not treated as additions to cost basis, but the kinds of improvements that would need to be made after a Hurricane caused substantial damage would likely qualify.
See IRS Publication 523, and the section on “Improvements” for the types of work that may qualify.
To the extent your cost basis is increased by the costs of these improvements, it’s already effectively reduced your gain.
– Michael
Very informative article and I really enjoy reading it! Could you make another analysis with this scenario? A couple bought a duplex in 2002 for $200k and sold it in 2006 for $600k in an exchange for an apartment of $1m. Today this apartment is worth of $2m. If this couple decides to sell this apartment in exchange for 4 single family homes at $500k each with intention to take advantage of tax exclusion in the next 20 years. What is their tax consequences assuming that the 4 family houses will also be sold for $500k in the future? Thank you in advance!
Im looking to sell my primary home in Texas (Lived in for 10 years) to payoff the property I plan to retire in (Maui, Hawaii) and also sell my rental property in Texas I originally moved into in 1995 and began renting in 1997 to use as a down payment on a primary residence in Oregon where my new job will be located. Thus years 1997 thru 2009 would be excluded years for capital gains taxes on the 1031 exchange I am pondering.
Most important issue to me is: Can I use a 1031 exchange to purchase the new resident in Oregon and move in right after closing or do i have to rent it first before moving in?
Would it be better or is it required that I make my Texas rental my primary residence first and then use a 1031 exchange to purchase the property in Oregon I plan to move into.
My desire is to stay in the Oregon home for 10 years and either keep it as a rental when I retire or 1031 exchange it for another property.
I have a quick question about the 2 years of occupancy out of 5 years for the main residency. The closing of the house is going to put us in a 23 month rather than 24 month occupancy. Does this mean that we will have to pay the full capital gains tax or can it be adjusted due to the fact that it is only a month off?
Great article. One additional scenario I have a question about. I sell my primary residence and move in to a rental home I’ve had since 2009. I plan on making that my new primary home for over 5 yrs. How would that be taxed upon the sale?
Great article, Mike. I have a couple of questions. Here are some facts. I converted a long-time primary residence (Property A) to a rental (when I moved out of state) and rented it for four years, then sold it and did a 1031 exchange into Property B. I also currently own a PR (Property C). I am considering selling my PR (which I have owned for two years) and take advantage of the Section 121. I have a caretaker opportunity (to live rent-free in exchange for caretaker duties, or pay minimal rent for a PR. QUESTION 1: Is it necessary that I OWN my primary residence, or can I rent or live in a property someone else owns while I have a 1031 rental property?
QUESTION 2: If I sell Property B (the 1031 rental, which I have only owned for 1 year) and buy another rental that costs more, am I allowed to just roll into another 1031 on the new property? If so, am I allowed to add funds received from the sale of my PR to the down payment on the new 1031 property?
QUESTION 3: Expanding on Question 2, if I wanted to covert the new 1031 property (call it Property D) into my primary residence after 2 years, would that be allowed, and what would be the ramifications?
Thanks.
Hi Michael, I bought a property in California in October 1992. Lived in this property through December 2003. Turned this property into a rental from December 2003 through July 2014. I moved back in to this property (as primary) since August 2014 to present time.
Question, if I sell this property later this year (2017), what would be the: a) non-qualifying years?; b) qualifying years?
Thanks in advance for your help.
Hi Arthur, curious to know, how this turned out for you. I am in a similar situation. Thanks
First I wanted to thank you for this chain discussion, it’s been very informative. I have a question for the group. I have a home that my wife and I lived in from 2007 to 2009. At the possible peak of the turn down both my wife and I lost our jobs so we rent out our primary residence to prevent losing it. Roll the clock forward the home is still rented, and it’s been throwing losses because of the interest paid and depreciation. Conservatively we have some 60k in combined losses. I’ve been thinking of taking our house back, but was not sure a primary residence – then converted to a rental – and then converted back would be eligible to recapture reported losses if the rental is no longer a viable business. Thoughts?
I bought 3 family building and live in one unit. What is my tax liability after a sale.
Thank you very much for the informative article. Question:
When doing a 1031 Exchange from a rental property to another rental property, when can I make the new rental property a primary residence without jeopardizing the tax benefits of a 1031 Exchange? Do I need to wait 12 months? Can I make it primary residence one day after I make purchase?
Thank you so much.
Anthony,
To qualify as a 1031 exchange, the rental property must be exchanged to another rental property. If you moved into the new property a day after purchase, it would be pretty easy for the IRS to demonstrate there was no intent for it to be a rental property, since it was never rented and never even made available for rent before moving in.
There is no specific waiting period prescribed by the IRS. It’s a “facts and circumstances” based test. You need to be able to demonstrate that the new property was in good faith intended to be a rental property – so actually rented for some period of time, or at least clearly made available TO rent for a period of time.
Realistically, 12 months of actual rental activity would very likely suffice, and moving in 1 day after clearly would not. Anything in between is a gray area. It all hinges on your ability to demonstrate an intent to have the new property actually be bona fide rental property to complete the 1031 exchange.
– Michael
Thank you for the very detailed scenarios. They help tremendously in understanding the implications of the law change in 2009. We are considering a move with one of our rentals and based on your example, I would like to confirm we are interpreting the implications correctly. Here is the scenario: Purchased a primary residence in 1990. Converted it to a rental in 1995. 1031 exchanged the property to another rental in 2002 and it has been a rental ever since. We are considering 1031 exchanging it again to another property that we might make our primary residence in the future. Let’s assume we 1031 exchange it this year (2017) – rent it for two years to satisfy the 1031 exchange rules then move into it and live there for 5 more years and sell. I realize all of the depreciation from 1995 on will need to be recaptured at the sale. I am assuming the capital gains would be calculated in the following way: 11 non-qualifying years (2009-2019 as a rental) and 24 qualifying years (1990-2008 and 2020-2024). So 13/24 of the gain would qualify (assuming under 500k) and 11/24 would be capital gain taxed. Is this accurate? I guess a simpler version of the question is does our years of ownership go all the way back to the original purchase in 1990 as a primary residence? Thank you for your help!
I have a friend with a second home that has been used as a rental for years. Now she wants to sell what has been her primary residence and do a 1031 exchange on the rental property to get another primary residence. Is this possible, or is there another way to proceed that you would recommend ?
Great article…I have a question that I hope you can help with. I am considering purchasing a rental property which I would pay off in 5 years (which I am guessing will have appreciation over this period, let’s say 3%). At the end of 5 years, our goal is to knock down the house and build a primary residence that we would live in for over 5+ years…what tax implications/ or method of transition could/should apply?…have not found an answer anywhere…Thanks!
Very clear and very helpful examples – thank you!!
I am 71 years old. I’ve been in retirement for 9 years. I have two homes of which one is considered Primary and one is a beach home purchased during 1994 that has never been rented. I would like to sell my primary and occupy my beach home, Since my retirement my wife and I have lived in the beach home four months every year. What would our tax be considering the 5 year/ 2 year current rules??
I have a question, in order to get the tax exemption does it have to be 2 years down to the day? Or is it with in the same year? We have our house for sale, and have lived there with in the last 2 years out of 5 but by the time it sells and closes it may be 1-2 months over but still with in the same year. example we moved out September 28th, 2014 and Closing will happen October 29th 2017 for the sale? Will we be ok as long as its still with in 2017 or since its past the move out “day” do we no longer qualify?
Michael,
Can you assist with the following scenario:
We purchased a home in 2000 for $200,000 and used as a primary residence for 4 years. It was a rental from 2004-2014 and we have since moved back into the home for 2 years as a primary residence. If we were to sell it now for $450,000, what would the tax ramifications be? Also, does it matter that most of the appreciation in the property took place prior to 2009 or does it only matter what the gain is and now when the actual gain took place? We were not aware of the 2008 tax change or would not have kept the home as a rental… Any assistance is appreciated.
We have lived in our primary residence for 27 years. We live upstairs and rent out the downstairs. We want to move to a location nearer the city center. Six months ago we sold a rental property and bought a townhouse in the area we want to live.
We paid $125,000 for a single story house in 1985. We moved into it in 1990 and built the upstairs living area (self builders) and spent $90,000 doing that. We began renting out the downstairs in 1992 and have lived upstairs since then. The property is now assessed at $992,000.
What would our tax consequence be if we sold our primary+rental and moved into our townhouse now?
Thanks for this article. It contradicts the advice I got from the attorney that handled my 1031 exchange this summer in some ways. A quick view of my situation:
I sold a property that had been in service as a rental from 2003 until the time of sale in May 2017. I used a 1031 exchange to buy a new investment property in August. I’ve been fixing it up for several months and am ready to rent it out, but I am having trouble finding tenants, and am currently carrying the mortgage for the rental property and my current primary residence. The attorney who facilitated the 1031 exchange said that we would be ok renting for a year and then converting the new rental to our primary residence if needed (the need being based on the idea that my current primary residence will be easy to sell, and I cannot afford two mortgages for two years without tenants). Thoughts about this? We now have it advertised for rent (have not been advertising the whole time due to renovations) but aren’t getting any candidates. If I can find tenants to rent it for less than what I really need until August (one year after purchase), could I then make it a primary residence based on the lack of expected performance as a rental? Hope this isn’t too complex a scenario, and would really appreciate your thoughts.
Great informative article. I have a question as I purchased a property in 1995 and lived there till 2007. I have rented it out from 2007 till now 2018 and I am thinking about moving back with my wife this year and living there for 2 years.
I have about a $$400,000 gain and was wondering how this would be calculated for capital gains. Seems like from 1995 to 2009 would be exempt from capital gains and so would 2018 to 2020. The years 2009 to 2018 would be subject to capital gains. So in summary I would have 11 years not subject to capital gains and 9 years subject to capital gains or about 55% or $220,000 not subject to capital gaIns but would be subject to any depreciation.
Is the above correct interpretation of the rules in your article?
Thank you for the article,
We just sold a rental property and purchased a house in which we want to retire using a 1031 Exchange, only to discover that the 1031 constrains us to continue renting it for another two years before we can move into the house. So reluctantly we made plans to postpone living there and rent for 2 years. Our assumption at this point is that after we move in, we must live there 2 years to make the house officially our homestead for purposes of benefiting from the homestead exemption. The entire process – or so we thought – ought to take 4 years. At the end of 4 years, we told ourselves, if we need to downsize because we are getting older (70+), we are free to do so and will benefit from the exemption. But since then I read that you can’t benefit from the homestead exemption on a 1031 Exchange property for at least 5 years. Is this true? If so, it means that living there 2 years is not enough. We must live there 3 years. THIS IS REALLY CONFUSING.
What happens to the depreciation life when you convert from Schedule E to personal. For example I depreciated for 10 years and on June 1st, I convert it to personal use. Does depreciation stop at 10.5 and continues when I convert it back to a rental. Or does depreciation continues but I don’t get a tax benefit.
I sold my primary residence in September 2018. Owned since 1997. I relocated in 1998 for a temporary job assignment until 2000. I took deprecation and expenses on the property for the years out of home in 1998, 1999, and 2000. I moved back into the property in mid-year 2000 and lived in the home until the sale in 2018. Do I have to recapture the deprecation and expenses with the sale of the home 18 years later?
Really well explained for a situation that it looks like a lot of people are in. I had a rental property from 1991-2018, that I exchanged in a 1031 for another rental in 2018, deferring a large gain. I plan to move into the new rental when I retire perhaps in 2021. So, as I read the article, I have 19 years of qualifying time (1991-2008), and 13 years non-qualifying (2009-2021), plus more qualifying if I live there for several years thereafter.
My only question is anyone knows any way to avoid some or all depreciation recapture on depreciation taken since 2000. And does the recapture include all the depreciation I took on the original rental since 2000, or just the depreciation taken on the new rental.
can I sell a second home if I live in it for two years, without having capital gains IE: I bought it for 229,000 and sell for 260,000?
I am buying a house next month with a rental on it primarily for the land value (urban Houston). There is a month to month tenant on the property which I will keep to offset holding costs while I design the home and I close on my bank loan for new construction. The hold time will likely be 3-4 months until the new construction loan closes. At that point I’ll kick out tenant, tear down/move the house and build new construction which I will move into about 12 months later. I plan to live in the house 2-3 years and sell for a tax free profit from a section 121 exclusion since it will be my primary house.
I have multiple rent homes some generating a tax profit by now so writing off expenses on the 3-4 month hold cost at this rented house is worth something to me. Appraiser said structure is worth $5k so my depreciation is negligible in this timespan. Haven’t found this situation online yet as most people don’t tear down a rental but this is in a HCOL urban neighborhood where new construction comps are high and I got a good deal on the lot.
My questions are:
1) Assuming the timeline above, 4 months rental, 12 months personal home construction, 24 months primary residence then sale for 121 exclusion, how does the non-exclusion-eligible taxable portion prorate? 4/(4+12+24) = %10 of profit to be Long Term gains taxed? Or because the original structure is worth basically nothing and I’m building new is 100% of the profit eligible for 121 exclusion since I will live there 2+ yrs? Does the construction period count as part of my 2 yr test for 121 exclusion?
2) I have other SFH rentals I just Schedule E and that’s it. So do the rental losses get to offset other Sch E income when I tear down and build new? (assuming I Schedule E this property for the 3-4 months it’s a rental)
3) is this all too much headache and is the $800 bucks a month income not worth the blip/headache to my Schedule E portfolio even though taxes, interest etc could be a write off for those months?
Thanks
Hi Michael,
Just looking to make sure I am understanding this correctly. We have a property that we purchased in 1996 and it was our primary residence until 1/2009. It is now a rental property. We are thinking of moving back into in the next few years to establish it as a primary residence. So assuming we move back in 2022 and live there for 3 years how would my capital gains look?
Or if I was to sell it today for a profit I assume I am on the hook for all the capital gains and depreciation recapture – correct.
House was purchased in 1996 for 150k and is now worth 450k.
I wanted to click five stars, but a message popped up after I clicked only two of the five stars. Please consider using a number selection system and not making people select multiple stars, which could lead to errors.
I have a primary residence and it is payed off and I have investment property, can I pay off my investment property and move in to my investment property and put that as my primary residence?
Hi I have a question about my Duplex. There are two floors, one of which I live in and the other where I rent out. Would capital gains exclusion apply to the sale of my home if I also live in my rental property?
My rental property is a single family dwelling house located in Utah. I was reassigned with the military and unable to sell the house. I have been renting the house out since @Jan 1989. Original purchase price in 1985 was @$54,000; Zillow now values it at @$351k. I refinanced several years ago for an equity loan and still owe @$57k. I have one primary residence located in Florida since 1999. Can I just stop renting out the house in Utah and claim as another primary residence, or do I have to go through the 1031 process, buy a comparable property and abide by 1031 rules to avoid capital gains? I would like to stop renting it out and begin the process of selling within 5 years, and avoid as much taxes as possible. Thanks in advance
I have searched the internet and this website has the best answers. I still need some help and hope someone can guide me. I purchased a property in 2000 It is home with a granny unit both of which have been rented since 2000. My plan is to move into it for 2 years and sell hoping to avoid some capital gains but I am still trying to figure out the formula. My cost basis was $535423 and I have depreciated $352579 The home is worth around $975,000 How do I figure if I will be able to take the capital gain exclusion. Thank you
I have a same situation as yours. Almost the same cost bases and depreciation. We purchased a property in 1998 rented out till 2020, converted to a primary resident in 2021 and planning to live at least 2022 or 2023 then to sell.
My interpretation:
You can convert it to your primary resident, live for a minimum 2 years which gives you 8 years 2000 to 2008 as qualified use plus 2 more years of primary resident (which also meet the 2 years out of 5 years requirement) totals 10 years of qualified use/22 years in 2022 as an owner. If you sell at $975000 – $535423 = $ 439577 Long Term Cap. Gains. Your qualified exclusion is $439577 x 0.4545 = $199788 (10/22=0.4545).
The remainder of gains $439577 – $199788 = $239789 is taxable gains, apply the long term capital gains tax rates.
Your depreciation recapture $352579 x 25% = $88145
Also let’s don’t forget NIIT (Net Investment Income Tax) the excess of Modified Adjusted Gross Income over the following threshold amounts: $250000 for married joint or qualifying widow(er)
$125000 for married filing separately
$200000 for all other cases, single
Hi Michael,
Hope that all is well. I am getting ready to close on the sale of my rental property that I used as my primary residence from when my wife and I purchased it in 1996 through 2003 when we converted it into a rental property ever since. Based on your explanations below, if I purchased the house for $80,000 in 1996 and sold it for $249,000 would there be any exclusions or will I have to pay long term capital gains tax on the entire profit?
Thanks,
Alex
I was reading your website. I found it very helpful. Thank you.
I have a question.
Your website under “converting a rental property into a primary residence after a 1031 exchange” stated that:
“.now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange”
However, I found this IRS publication:
https://www.irs.gov/pub/irs-drop/rp-08-16.pdf
Is it 5 years or 2 years? I am confused. Please help!
We have a property purchased through 1031 exchange. The property is rented for 3+ years. We are planing to move there but I wanted to find out if we could without paying capital gain tax (since this was a 1031 exchange replacement property). We don’t plan to sell this property.
Thank you,
Ferda Yilmaz