Sell rental before capital gains tax?

Riverdale , GA · Member since 2013 · 42 posts · 2 votes

I am moving out of my current residence and plan on turning it into a rental. From what I can tell if I sell the house within 3 years after moving out, I will not have to pay capital gains tax. The rule is if you lived in the house 2 out of the last 5 years then no capital gains tax is needed, if the gains are under $500,00 which mine will be. So my question is, when does it make sense to keep the property as a rental longer than 3 years? I do not foresee keeping the property as a rental for more than 10 years, probably less. Any input?

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Bill ExeterBusiness Member

1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes

12y

There are two strategies that often get confused with one another. The first is when the investor owns rental property and decides to convert it into his or her primary residence (not the case here) and the second is when the investor owns a primary residence and decides to move out, convert it to rental property and ultimately sell it.

Rental Property to Primary Residence

@Steven Hamilton II description above is right on the money here. The taxpayer can cease to rent the property, move into it and convert it to their primary residence. If they 1031 Exchanged into the property, they must hold/own it for at least five years before they can qualify for the 121 Exclusion. If they did not 1031 Exchange into it, then the only have to live there for two (2) years in order to qualify for the 121 Exclusion.

When they ultimately do sell with the intent to take advantage of the 121 Exclusion, the capital gain will be "prorated" as Steve mentioned between the number of years the property was held as rental versus the number of years the property was held (and used) as your primary residence. The amount of gain allocated to the primary residence usage will be tax free up to the $250/$500,000 limit.

Primary Residence to Rental Property

@Dave Toelkes is right on the money here. If the property was always used as a primary residence, and the property owner decides to move out and rent the property, they owner has a three (3) window from the date he/she moves out to sell, close and qualify for the 121 Exclusion. The capital is not prorated in this case.

Also, the investor can also qualify for a 1031 Exchange in this case (Revenue Procedure 2005-14) as long as they can say they have owned and lived in the property as their primary residence for a total of 24 months out of the last 60 months AND the property has been rented out for a sufficient period of time to demonstrate they had the intent to hold for investment (generally 12 to 24 months). So, they could potentially receive tax free treatment for up to $250/$500,000 in gain and the balance (if any) would be deferred into another rental property via the 1031 Exchange.

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Brian Kelsch
Accountant · Center Conway, NH · Member since 2013 · 19 posts · 2 votes
12y
Your basic understanding is correct. If your are married filing jointly (MFJ) the gain exclusion on the sale of a personal residence is $500k. If you are single it is $250k.

However, if you turn it into a rental then you get into other rules regarding depreciation recapture from the date it became a rental. The tax rate on this recapture is 25%

As far as when it makes sense to keep it as a rental depends on a number of factors and normally taxes is down on the list. is it cash flowing? Is it appreciating? Etc.

Also if you sell it in 5 years your gain will not be the entire sale price. You have basis in the property which is among other things your original cost plus improvements over the years.
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Buddy LaRue
Involved In Real Estate · Palm Springs, CA · Member since 2011 · 144 posts · 78 votes
12y
@ Couldn't a 1031 be done on the property if he's been using for a rental for three years? That way he could defer the tax and still use the money for another property.
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Brian Kelsch
Accountant · Center Conway, NH · Member since 2013 · 19 posts · 2 votes
12y
@Buddy LaRue yes, a 1031 is an option. The rules for these can be a bit complex and lengthy for a post. But if @Kelly Williams wanted to get a another property I would considering selling within 3 years and using the cash to buy another without using a 1031 intermediary.
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Account Closed
Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
12y
Originally posted by Buddy LaRue:
@ Couldn't a 1031 be done on the property if he's been using for a rental for three years? That way he could defer the tax and still use the money for another property.

Why would you want to defer the tax when you can walk away with the gain tax free?
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Brian Kelsch
Accountant · Center Conway, NH · Member since 2013 · 19 posts · 2 votes
12y
@Account Closed I agree that is why i bring up sell it within 3 years. however, I also suggest that looking at other factors should be a higher priority; other investment options vs. current home
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Account Closed
Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
12y
Originally posted by Kelly Williams:
So my question is, when does it make sense to keep the property as a rental longer than 3 years? I do not foresee keeping the property as a rental for more than 10 years, probably less. Any input?

When you don't have much capital gains now, and the property can generate positive cashflow with long-term appreciation potential. Based on my experience, your primary residence typically doesn't make a good rental.
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Account Closed
Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
12y
Originally posted by Brian Kelsch:
@Account Closed I agree that is why i bring up sell it within 3 years. however, I also suggest that looking at other factors should be a higher priority; other investment options vs. current home

Oh god. I think I just repeated what you said above with respect to long-term appreciation and positive cashflow, etc. Hehe.
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Kelly Williams
OP
Riverdale , GA · Member since 2013 · 42 posts · 2 votes
12y
Wow, thanks for all of the quick responses. Great conversation here. So the property will cash flow pretty well. The appreciation factor is my main reason for not selling when I move. It seem to me that there would be a rule of thumb, to figure if a sale would benifit before the 3 years. Similar to the rule of needing to own a primary residence for 3 years to make it profitble?
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Brian Kelsch
Accountant · Center Conway, NH · Member since 2013 · 19 posts · 2 votes
12y
Not sure if this would be a rule of thumb...but you need to comapre your cash flow from renting plus your appreciation versus the tax cost of holding onto the property.
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Kelly Williams
OP
Riverdale , GA · Member since 2013 · 42 posts · 2 votes
12y
That is what I was thinking. I guess it is just the unknown value of appreciation that I am concerned with. I was hoping for a calculation i guess. Something like value must appreciate by x amount. It will probably be a much easier decision in 2.5 years when I have a better idea of the amount of appreciation the home has gained. For what ever reason, I just realized last night about the 5 yr rule with no capital gains. It kind of put a kink in my 5 year plan of renting the home. thanks again for all of the quick responses.
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Brian Kelsch
Accountant · Center Conway, NH · Member since 2013 · 19 posts · 2 votes
12y
@Kelly Williams Yes, it can be calculated but there is a ton more information needed. Your tax bracket, your basis in the property, your cash flow from the rental, etc....
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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
12y
Originally posted by Kelly Williams:
That is what I was thinking. I guess it is just the unknown value of appreciation that I am concerned with. I was hoping for a calculation i guess. Something like value must appreciate by x amount. It will probably be a much easier decision in 2.5 years when I have a better idea of the amount of appreciation the home has gained. For what ever reason, I just realized last night about the 5 yr rule with no capital gains. It kind of put a kink in my 5 year plan of renting the home. thanks again for all of the quick responses.

@Kelly Williams ,

They gave you perfect information to think about. The one thing I would say to consider is sell it now. Then buy another property. This locks in your excluded gain.

What was not mentioned was this issue: if you hold it as a rental YOU MUST allocate gain between the ratio of personal years to rental years.
This means if you owned it for ten years and it was a rental for 3, you will have to allocate 30% of the gain to the rental years. Also keep in mind you will have recapture.

My advice: take the money and invest it into a property that is more efficient as a rental.
[email protected]224-381-2660
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Kelly Williams
OP
Riverdale , GA · Member since 2013 · 42 posts · 2 votes
12y
@Steven Hamilton II , I don't understand. What do you mean by allocate the gain to the rental years? Please explain. Thanks.
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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
12y
Originally posted by Kelly Williams:
@Steven Hamilton II , I don't understand. What do you mean by allocate the gain to the rental years? Please explain. Thanks.

@Kelly Williams ,

That means if you lived in it for 3 years and rented it out for 2. So you owned it for 5 years. You would have to allocated 2/5 of the gain to the rental years. Allowing you to only exclude 60% ( 3/5 ) of the gain. You would pay tax on 40% (2/5) of the gain.

SO if you gain over 5 years was 50k. You would pay tax on 20k and nothing on 30k of gain.

Does that make sense?
[email protected]224-381-2660
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Wayne Brooks
Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
12y
Sell now, lock in the excluded, tax free gain, buy similar property and get the same appreciation......win win.
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Kelly Williams
OP
Riverdale , GA · Member since 2013 · 42 posts · 2 votes
12y
@Steven Hamilton II , I cant find in the tax code where this is the case. As far as I can tell if the property is your primary residence, any 24 months of the last 5 years you pay zero capital gains tax. I am definitely not the expert here, but can you show me how this is the case? Thanks again for the input.
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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
12y
Originally posted by Kelly Williams:
@Steven Hamilton II , I cant find in the tax code where this is the case. As far as I can tell if the property is your primary residence, any 24 months of the last 5 years you pay zero capital gains tax. I am definitely not the expert here, but can you show me how this is the case? Thanks again for the input.

It is different if you then rent it out. It becomes business use. You have to allocate for the business use.

@Bill Exeter will more than likely agree with me.

Here is the link to the tax code: IRS Code Section 121

(4)?1 Exclusion of gain allocated to nonqualified use

(A) In general
Subsection (a) shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.
(B) Gain allocated to periods of nonqualified use
For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—
(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to

(ii) the period such property was owned by the taxpayer.

(C) Period of nonqualified use
For purposes of this paragraph—
(i) In general The term “period of nonqualified use” means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.

(ii) Exceptions The term “period of nonqualified use” does not include—
(I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse,
(II) any period (not to exceed an aggregate period of 10 years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty (as defined in subsection (d)(9)(C)) described in clause (i), (ii), or (iii) of subsection (d)(9)(A), and

(III) any other period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the Secretary.

(D) Coordination with recognition of gain attributable to depreciation
For purposes of this paragraph—
(i) subparagraph (A) shall be applied after the application of subsection (d)(6), and

(ii) subparagraph (B) shall be applied without regard to any gain to which subsection (d)(6) applies.

[email protected]224-381-2660
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Kelly Williams
OP
Riverdale , GA · Member since 2013 · 42 posts · 2 votes
12y
Well that may change everything. @Steven Hamilton II thanks again for your help. The numbers you used as an example earlier are actually pretty accurate. I will have lived in the house for three years before I move out. So, if I were to rent it for three more to use the 5 yr rule I would still have to pay capital gains tax on 50% of the gains.

I will take that into account. I guess I have some calculations to do. The house will cash flow about $500 per month. I just refinanced this summer so my payments will not begin to make much of an impact on the principal for a few years. The house is in a great part of the city that is currently going through major gentrification. Scrapes and remodels are popping up on my street every day. The property has already appreciated 20% in 2 years. I think there is still plenty of room for more growth. This has been my reasoning for wanting to hold onto it. @Wayne Brooks buying a similar property with similar appreciation would be very difficult to find. not to mention my loan on this property is at 3.5%. thanks again for everyones help.
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Dave Toelkes
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
12y
@Steven Hamilton II

(ii) Exceptions The term "period of nonqualified use" does not include—

(I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer's spouse,

If I interpret this correctly, it sounds to me that the period of rental use during the five year look-back period prior to sale might not be counted as a period of nonqualified use. If so, then in your example where the property was owned and occupied as a primary residence for two years, then rented for just less than three years before being sold, the entire five year period prior to the sale is qualified use, and 100% of the gain is excluded under section 121.

Appreciate your feedback.
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Pete T.
Real estate investor · Las Vegas · Member since 2013 · 798 posts · 171 votes
12y
Yes, this is an area where I get conflicting answers from CPA's etc. I have been told I would be good for the whole 5 year period and I have been told it was a percentage. I have also been told it wouldnt matter if I sold it (because it would currently be at a loss), but I dont think that is right due to the recapture.
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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
12y
Originally posted by Dave T:
@Steven Hamilton II
(ii) Exceptions The term "period of nonqualified use" does not include—
(I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer's spouse,

If I interpret this correctly, it sounds to me that the period of rental use during the five year look-back period prior to sale might not be counted as a period of nonqualified use. If so, then in your example where the property was owned and occupied as a primary residence for two years, then rented for just less than three years before being sold, the entire five year period prior to the sale is qualified use, and 100% of the gain is excluded under section 121.

Appreciate your feedback.

@Pete T. ,

That is possible, the numbers would have to be run.

@Dave Toelkes ,

That is correct that if it happens after it was the residence, yet they would STILL have depreciation recapture.

I would still sell and buy another if it all possible as you would have a cleaner basis for depreciation.
[email protected]224-381-2660
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
12y
There are two strategies that often get confused with one another. The first is when the investor owns rental property and decides to convert it into his or her primary residence (not the case here) and the second is when the investor owns a primary residence and decides to move out, convert it to rental property and ultimately sell it.

Rental Property to Primary Residence

@Steven Hamilton II description above is right on the money here. The taxpayer can cease to rent the property, move into it and convert it to their primary residence. If they 1031 Exchanged into the property, they must hold/own it for at least five years before they can qualify for the 121 Exclusion. If they did not 1031 Exchange into it, then the only have to live there for two (2) years in order to qualify for the 121 Exclusion.

When they ultimately do sell with the intent to take advantage of the 121 Exclusion, the capital gain will be "prorated" as Steve mentioned between the number of years the property was held as rental versus the number of years the property was held (and used) as your primary residence. The amount of gain allocated to the primary residence usage will be tax free up to the $250/$500,000 limit.

Primary Residence to Rental Property

@Dave Toelkes is right on the money here. If the property was always used as a primary residence, and the property owner decides to move out and rent the property, they owner has a three (3) window from the date he/she moves out to sell, close and qualify for the 121 Exclusion. The capital is not prorated in this case.

Also, the investor can also qualify for a 1031 Exchange in this case (Revenue Procedure 2005-14) as long as they can say they have owned and lived in the property as their primary residence for a total of 24 months out of the last 60 months AND the property has been rented out for a sufficient period of time to demonstrate they had the intent to hold for investment (generally 12 to 24 months). So, they could potentially receive tax free treatment for up to $250/$500,000 in gain and the balance (if any) would be deferred into another rental property via the 1031 Exchange.
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