Avoiding Capital Gains on Rentals

7 Replies

I'm reading conflicting things regarding capital gains on rentals.  According to the IRS site, it looks like one can live in a rental property for 2 of the past 5 years, even if that property was acquired as a 1031 exchange.  One must keep the property for a minimum of 5 years.  My understanding is that if I do this, for each of my two rental properties, then I can avoid capital up to $250K (I'm single). Only selling one property every two years of course.  

Now...I recently read an article stating that, for example, I have the property for 5 years, I live in it for 2 of the 5 years before selling, and it's a rental for the other 3 years.  I would only be able to avoid 2/5 of the capital gains, due to the fact that I lived there only 2 years (qualified used), but the other 3/5 of the gains would be taxable because I didn't live there, it was a rental for 3 years (unqualified use).  I'm not seeing anything about this on the IRS website, however.  

Can a tax attorney or a CPA advise?  I'm considering doing a 1031 exchange on two rentals, purchasing in a different city, and over the next 5-10 years, I would live in both of them for 2 of the 5 years before selling them.  (maybe...who knows how life changes!  haha, but that may be the plan for now). I'd really like to have some solid knowledge on this before doing a 1031 exchange as depending on what the deal is, I may just keep the current rentals.  

Thanks in advance!

  

Updated about 1 month ago

Thank you everyone for the clarification!

@Jillian Skinner , [Disclaimer:  Not a Tax Accountant].  Seems to me you'd be "safer" if you buy each of them as your Primary in the first instance, one at a time.  Then move out after 2 years, selling before 5 years is fulfilled.  Otherwise, I can well see how "the other 3/5 of the gains would be taxable because I didn't live there" (from day one).

If you're thinking of buying multiple rentals in year one, guess how many will theoretically be able to avoid Capital Gains Tax after 5 years (if you only intend to live in one for the final 2 years)?  [Hint: One (and maybe not even that many)].  And for each 2 years that then goes by, guess how many years you haven't avoided CGT on the rest of them? [Hint: At least 2 years more, and counting].

Solution?  Buy ones in areas that don't increase in value!  And/or, keep them forever.  

Or, here's an idea: Just pay the CGT and be chuffed that you're doing your bit!  Cheers...

If it’s a rental first, the percent of time owned that ou lived there is tax free, the 2 of 5 rule doesn’t apply as our predecessors “used the heck” out of that tax advantage when they wanted to sell. 

If it’s a primary first you can sell and take advantage of the capital gains tax free sale if you live there 2 of 5. (Still have to pay depreciation recapture.)but with selling and acquisition costs you have to be shielding a big gain to make it worth selling and starting over. Almost half my rentals were primary’s first and I still own them 10 years later. I used them for the lower downpayments and better rates, not so I could sell within 3 years. 

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@Jillian Skinner ,  There's a lot of confusion between sec 121 (your primary residence) and 1031 (investment real estate).  But the confluence between and ability to covert either way to your benefit is very powerful.  If you do a 1031 exchange and then later convert that property into your primary residence here's what it looks like.

1. Once you have established your intent to hold for investment use you convert it by moving in.

2. Once you have lived in it for 2 out of the 5 years prior to sale (yep still a requirement)

3. And once you have owned it for at least 5 years (a requirement since it was once a 1031)

4. You can sell and take a proration of the gain for the time you lived in it under sec 121.  And you will pay tax for the proration of the time it was used for investment.

5. And you will have to recapture all depreciation.

Anyway you slice it it is a good deal - part tax free and part taxed.   May folks have a retirement job that is taxed delivering pizzas.  Your taxed retirement job can be moving once in a while and creating some tax free income.

Originally posted by @Jillian Skinner :

I'm reading conflicting things regarding capital gains on rentals.  According to the IRS site, it looks like one can live in a rental property for 2 of the past 5 years, even if that property was acquired as a 1031 exchange.  One must keep the property for a minimum of 5 years.  My understanding is that if I do this, for each of my two rental properties, then I can avoid capital up to $250K (I'm single). Only selling one property every two years of course.  

Now...I recently read an article stating that, for example, I have the property for 5 years, I live in it for 2 of the 5 years before selling, and it's a rental for the other 3 years.  I would only be able to avoid 2/5 of the capital gains, due to the fact that I lived there only 2 years (qualified used), but the other 3/5 of the gains would be taxable because I didn't live there, it was a rental for 3 years (unqualified use).  I'm not seeing anything about this on the IRS website, however.  

Can a tax attorney or a CPA advise?  I'm considering doing a 1031 exchange on two rentals, purchasing in a different city, and over the next 5-10 years, I would live in both of them for 2 of the 5 years before selling them.  (maybe...who knows how life changes!  haha, but that may be the plan for now). I'd really like to have some solid knowledge on this before doing a 1031 exchange as depending on what the deal is, I may just keep the current rentals.  

Thanks in advance!

  

 Non-qualified use is the rental time period before the 2 years of your personal use. If you lived in the house for 2 years (no prior rental) and rent the rest of the 3 years, there is no non-qualified use. 

Nonqualified Use.

The gain exclusion from the sale of a principal residence ($500,000 for joint filers and $250,000 for single filers) is not available to taxpayers for periods of nonqualified use. Nonqualified use is any period after 2008 that the property is not used by the taxpayer, or the taxpayer's spouse or former spouse as a principal residence (i.e., rental, business use, etc.).

However, nonqualified use does not include any period of such use that occurs

(1) any time during the five-year period ending on the date of the sale that occurs after the last day of use as a principal residence,

or (2) any time (up to two years) that the taxpayer is temporarily absent due to a change in place of employment, health, or unforeseen circumstances.


 Any early nonqualified use will forever taint the property and some portion of the gain will be taxable (unless a step-up in basis occurs under IRC Sec. 1014 after the death of the taxpayer)

When sec121 qualified property with non-qualified use is involved in 1031: (non-qualified period tacks on)

Depreciation: In other words, where a taxpayer's residence is the relinquished property in a tax-free exchange, any gain attributable to depreciation deductions relating to the residence can be deferred until the taxpayer disposes of the replacement property received in the exchange.

Gain: The Code Sec. 121 exclusion has to be applied to gain realized before applying the nonrecognition rule of Code Sec. 1031

Illustration 1: A, an unmarried individual, buys a house for $210,000 that A uses as his principal residence from Year 1 to Year 5. From Year 5 to Year 7, A rents the house to tenants and claims depreciation deductions of $20,000. Thus, the house had been used in A's trade or business or held for investment within the meaning ofCode Sec. 1031(a) as well as used as a principal residence as required under Code Sec. 121. In Year 7, A exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that A intends to rent to tenants. A realizes gain of $280,000 on the exchange.

A's exchange of a principal residence that A rents for less than three years for a townhouse intended for rental and cash satisfies the requirements of both Code Sec. 121 and Code Sec. 1031. Code Sec. 121 does not require the property to be the taxpayer's principal residence on the sale or exchange date. Because A owns and uses the house as A's principal residence for at least 2 years during the 5-year period before the exchange, A may exclude gain under Code Sec. 121. Because the house is investment property at the time of the exchange, A may defer the gain under Code Sec. 1031

A applies Code Sec. 121 to exclude $250,000 of the $280,000 gain before applying the nonrecognition rules of Code Sec. 1031. A may defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under Code Sec. 1031. For why A doesn't recognize the $10,000 of cash (boot) received in the exchange. These results are illustrated as follows.

Amount realized . . . . . . . . . . . . . . . . $470,000

Less: Adjusted basis . . . . . . . . . . . $190,000

Realized gain . . . . . . . . . . . $280,000

Less: Gain excluded under Code Sec. 121 . . $250,000

Gain to be deferred . . . . .. . . . $ 30,000

I don't know how the tax rules work in the US, but remember if you are paying capital gains it is because your house appreciated in value.  When you sell, you have a lot of other fees (which you can claim), but if you are selling every 5 years balance the tax benefits (I'm in Canada and our rules are different) with the costs.  Realtor's fees can take a big chunk of that money.