Pitfalls and Planning Opportunities When Moving Into Your Rentals

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I always find it interesting that our tax world keeps getting more and more convoluted.  In fact I was just reading on Forbes Magazine that since 2001 Congress has made nearly 5,000 changes to the Tax Code.

To make things worse, not only are the changes more frequent but the tax rules are also getting more complex by the minute. Let’s take the example of a simple real estate scenario:

Did you know that turning a primary home into a rental has very different tax consequences than a turning a rental into a primary home?

That’s right! If you have a property that you turn from a primary home into a rental property it can have significantly better tax benefits than a rental property that you later decide to move into.

Just how do they differ? Well, let’s take a look at two fictitious taxpayers Mary and Jerry.

Primary Home Turned Rental

Mary and her husband lived in their home for over 6 years.  Once they had their 4th child they decided they needed more room and needed to move into a bigger home.

Being investors themselves, Marry and her husband decided it would be a good idea to keep their home as a rental property. Luckily for Mary, two years down the road the home appreciated in value and she was able to sell the home for a nice gain of $100,000.

Related: Investing for Cash Flow or Appreciation – What’s the Difference?

For Mary, she was able to get $100,000 of this gain free from taxes because she sold her house within the IRS allotted time frame. Mary was able to use a primary home gain exclusion on her home because the property was her primary residence in two of the preceding five years. In fact, had the real estate market sky-rocketed in value, Mary and her husband could have received up to $500,000 of gain free from taxes.

Furthermore, there is no limitation on how many times the exclusion may be used during someone’s lifetime so a few years from now, Mary and her husband could potentially sell their new home and use the $500,000 gain exclusion again.

As real estate investors, this is a nifty loophole that can help you to build up your wealth in a tax-free manner over time. In fact, I have a few clients that use this strategy consistently every few years to trade-up their home and lock in the appreciation free from taxes. The catch is of course that you should make sure that your family is on the same page with you in terms of moving every few years.

To qualify for the home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your two years of ownership and use can occur anytime during the five years before you sell—and you don’t have to be living in the home when you sell it.

Rental Turned Primary Home

Now let’s go to our next taxpayer Jerry. For Jerry, he had a rental property that he purchased back in 2010 for $150,000.

In 2012, after two years of renting it out, Jerry and his wife decided that it made sense for them to move into this rental property as their primary home. Two years after moving in to the property, the home value appreciated significantly and Jerry decided to sell the property for $250,000 in 2014 and move his family into a nicer home.

Unlike Mary, Jerry was not able to exclude the entire $100,000 gain from taxes. The reason was due to a special rule that was enacted in 2009 that puts limits on people who sell a primary home which initially started out as a rental property.

Related: The 5 Things You Will Probably Forget When Rehabbing a House Flip

The rule requires the property owner to reduce the amount of profit excluded from income based on the number of years after 2008 in which the property was used as a rental on a pro rata basis.

In Jerry’s example, the property was a rental during two out of the 4 years that he owned the property.  As such, the amount that he was able to exclude as taxable income to him was only $50,000.

Now what if instead of selling the property in 2014 Jerry and his wife decided to move back into the property again and instead decide to sell it in 2015?

The good news is that under the IRS regulations, a nonqualified use can occur only before the home was used as the taxpayers’ principal residence. So the time periods after the home was used as Jerry’s principal residence does not constitute a nonqualified use.

Assuming that Jerry ended up selling the house for $250,000 in 2015 after having moved back into the property for another year, his taxable gain would then be reduced to two fifths of $100,000 or $40,000.

As you can see, the tax world can get complex when you are considering moving into or out of a property as your primary home. In fact, if you have turned your primary home into a rental in the last few years, you may want to meet with your advisor to determine whether it makes sense to sell your old home and lock in some tax-free capital gains.

Make sure you are planning ahead and meeting with your own tax advisor prior to making these moves to ensure that you maximize your tax savings.

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About Author

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

16 Comments

  1. So, If I decide to turn my primary into a rental after living in it for 2 years I could sell it and receive no tax in capital gains? would it be considered income? Also, What if I keep it as a rental and the house is paid off W/ No mortgage, Is there any tax implications with that strategy?

    • Yiu need to have lived in the property 2 of the last 5 years to qualify for the tax exclusion. So you could buy a home, live in it for 2 years and rent it out for 2.5 years and sell before the 3 year mark and get the exclusion. This would not work however if you kept it for 20 years and then tried to sell. After it being a rental for 18 years.

        • I buy a house as a primary to take advantage of lower down payments and better interest rates. After a year, to satisfy general occupancy requirements for the loan, I move out and hold it as a rental for the next 20 years.
          At that time I decide to move back in for 2 years. After 2 years I, and my wife, sell the place for a $500K gain.
          Since it started as a primary and I lived in it for the 2 years as my primary before selling would the gain be tax free (other than depreciation recover) since the “non-qualifying” period was after it was initially used as a primary?

        • Hi Shaun:

          You always have the best ideas! Unfortunately not that does not work. For the full exclusion it only works if you turn a primary into a rental the first time around ….meaning you sell it after it is a rental and without moving back into it again as your primary home.

        • While intuitively that makes the most sense, I’m just trying to resolve it with the way I read the points in the article.

          Does the gap or the percentage of time it was used as a rental make the difference?
          For example let’s say that we buy the place and live in it for 10 years. At that point I read one too many guru blogs about making millions in real estate. We move out and start to rent the place out. 2 years later it has been a disaster and we give up on REI and move back to the place for another 8 years.
          Now when we go to sell how is it treated? Started off as a primary, it had been the current primary for more than 5 years and 90% of total use was as a primary.
          Tax fee (other than depreciation recapture for those 2 years) or other exclusion?

          What is tripping me up I think is mostly the part where you said:
          “The good news is that under the IRS regulations, a nonqualified use can occur only before the home was used as the taxpayers’ principal residence. So the time periods after the home was used as Jerry’s principal residence does not constitute a nonqualified use.”
          Since in my mostly a rental and my mostly a primary example all the rental time was after being established as the primary first, so it seems like you should only have to meet the 2 out of 5 requirement because of that.

  2. @Amanda Han,

    Doesn’t Mary and her husband have to depreciate the primary home for the 2 years it was used as a rental and if so wouldn’t you have to recapture the depreciation benefit on sale?
    Or are you saying there all profit is tax free??

    • Hi Gautan: Correct…any depreciation taken would be recaptured as taxable provided that the property is sold for a gain. If the property is sold for no gain then there is no depreciation to be recaptured.

  3. This is a very insightful article. I did not know this so this was not a part of our “game plan”. I will definitely be sharing this article with my husband and see if we can get on the same page for this. Thanks for sharing!

  4. Amanda, real estate taxes are so overwhelming for newbies. Sometimes it seems like you’er doing deals just for the government. So I’m just a big believer in educating yourself so you know the laws.

    Amanda, what are some good places do you think people can go learn the tax laws?

    Antonio Coleman “Signing Off”

    • Hi Antonio:

      You can checkout my website Keystone CPA and we have some free resources. Also bigger pockets of course has a wealth of information on taxes as well (in case you havent noticed!). I would suggest you meet with your local investors to see about local CPAs holding classes specifically targeting real estate investors…those are often very informational also.

  5. Hi Shaun:

    The statement “nonqualified use can occur only before the home was used as the taxpayers’ principal residence” references the initia use (ie as a primary home) and does not apply to a second move back into the home. You will want to check with your tax advisor on how the pro rata calculation will impact your situation as I do not have any clients who had the same exact profile that fits the scenario you describe and I dont want to give you wrong advise on a blog site. If all else fails you can always look at the 1031x/keep until death strategy which I am sure you already know about =).

  6. From a tax perspective, what is the best use of the tax-free gains that are freed up upon sale of a primary residency? Say the gains are that easy-to-work-with number of $100,000 from the sale of a primary residence that has been occupied for 10 years. Roll it all into a larger primary residence, to rinse-and-repeat? Buy a fixer to occupy, to “force” equity gains? Buy several buy-and-hold rentals?

    Also, as we are military: the rules as I understand them are that we can occupy a residence for any 2 out of 10 years for tax-free gains. Do I understand that correctly?

    • Hi Kerry:That is a very good question and the answer will depend on what is the best return on investment with the proceeds. I do have clients that use your rinse and repeat example with primary homes and build up a nice tax-free equity position on their property. On the other hand if you can reinvest the proceeds in other properties and get better ROI then it may make sense. Yes for military there is an option to roll the 5 year window for up to 10 years. thanks for your comment!

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