Avoid capital gains on primary/rental property

14 Replies

I'm hoping that someone can help me figure out a tax question related to capital gains. This is really a two questions.

I've been reading about the exemption from capital gains if you occupy a primary residence for 2 of the last 5 years. I read that the time does not have to be consecutive, right?

If I rent a property for 2-3 years but still meet the 2 year rule, what happens to the depreciation I claim during the rental years? Does my cost basis just adjust or do I have to pay taxes on that amount separately upon sale of the property?

Just trying to wrap my head around this concept. We're actually six months away from the 2-year mark on our current primary but thinking about turning it into a rental. Just trying to strategize. Thanks!

Originally posted by @Loren Whitney:

I'm hoping that someone can help me figure out a tax question related to capital gains. This is really a two questions.

I've been reading about the exemption from capital gains if you occupy a primary residence for 2 of the last 5 years. I read that the time does not have to be consecutive, right?

If I rent a property for 2-3 years but still meet the 2 year rule, what happens to the depreciation I claim during the rental years? Does my cost basis just adjust or do I have to pay taxes on that amount separately upon sale of the property?

Just trying to wrap my head around this concept. We're actually six months away from the 2-year mark on our current primary but thinking about turning it into a rental. Just trying to strategize. Thanks!

Loren, 

Be very careful when toggling a property back and forth from rental to personal. 

When depreciating as a rental, be sure to use the lesser of Fair Market Value or your cost basis. Furthermore, when you sell the property any and all depreciation taken as a rental property must be recaptured as ordinary income regardless of whether you move back into the property or not. 

Any gain on the property would be excluded as taxable, just as long as you can show you used the property as a primary residence for any 2 years of the past 5. There is no rule requiring consecutive year ownership. 

Nathaniel Busch, CPA 

@Nathaniel Busch  I'm interested to know why you should use the lesser of fair market value or cost basis? Is this a legal requirement? 

Thanks!

Originally posted by @Chris Kennedy:

@Nathaniel Busch I'm interested to know why you should use the lesser of fair market value or cost basis? Is this a legal requirement? 

Thanks!

 Chris,

It's required by law.

IRS Publication 527

Basis of Property Changed to Rental Use

When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of fair market value or adjusted basis on the date of conversion.

@Loren Whitney 

You may want to check with your CPA.  While your profit from appreciation may be excluded from capital gains in your scenario, I believe the depreciation recapture cannot be excluded.  Depreciation recapture tax rate is 25% of the depreciation taken, or the depreciation that should have been taken whichever is greater.  

@Loren Whitney,

I wanted to expand on @Nathaniel Busch 's statement about being careful when toggling a property back and forth from rental to personal. You need to consider nonqualified use.

Pub 523 defines non-qualified use as:

Gain from the sale or exchange of the main home is not excludable from income if it is allocable to periods of nonqualified use. Nonqualified use means any period after 2008 where neither you nor your spouse (or your former spouse) used the property as a main home, with certain exceptions (see next).

One of the exceptions is:

Any portion of the 5-year period ending on the date of the sale or exchange after the last date you (or your spouse) use the property as a main home;

In summary, if you use a home as primary for 2 out of 5 years, then rent it for 3 years or less and sell it, you should be able to take the full capital gain exclusion. If you use the home as primary, then rent it, then use it as primary again, the capital gain exclusion will be prorated based on the number of days the property was rented out.

I think this article explains the issue well:

http://www.goldentax.com/4838/A-New-Twist-For-Home...


@Tatyana S.  

It is not the capital gain exclusion that gets prorated, it is the capital gain itself.

@Dave T  - thanks for the correction! I mislabeled.

@Nathaniel Busch

I recently sold my primary residence and took the capital gains tax exemption. Lived from 2011-13 and then rented and sold in 2015.  My current house I lived from 2013- current. Am I able to take another exemption when the 2 year mark comes up in afew months? My CPA (not a real estate specialist) says I can't take the exemption because I have to wait until tax year 2017. Is this true? He says I have to wait 3 years until I can take another exemption

@Rich Ferradino Your CPA is correct provided there are not exceptions to the norm at play. Generally, a taxpayer can claim the full exclusion only once every two years. A reduced exclusion is available to anyone who does not meet these requirements because of a change in place of employment, health or certain unforeseen circumstances.

General CPAs usually fully understand the Section 121 exclusion since it isn't really a real estate investor specific rule as it generally applies to everyone.

*Edit - just realized your CPA said you have to wait three years, which is incorrect. The wait time is 2 years.

@brandon Hall    Thanks for your input

Originally posted by @Tatyana S. :

@Loren Whitney,

One of the exceptions is:

Any portion of the 5-year period ending on the date of the sale or exchange after the last date you (or your spouse) use the property as a main home;

In summary, if you use a home as primary for 2 out of 5 years, then rent it for 3 years or less and sell it, you should be able to take the full capital gain exclusion. If you use the home as primary, then rent it, then use it as primary again, the capital gain exclusion will be prorated based on the number of days the property was rented out.

Does anyone mind clarifying the prorated calculation for this formula? From what I've gathered, it makes a difference if you begin using the property as a primary residence as opposed to buying a rental and occupying it after the fact to take the exclusion. 

I'm still having trouble determining my situation. I purchase a primary residence on 1/1/13 and begin renting it two full years later on 1/1/15. If I sell the property within three years, do I need to prorate gains or not? What about the opposite?

@Loren Whitney  - in the first scenario (primary for 2 years, rental for 3 or less then sell)  -- no proration and full exclusion.  In the opposite case (rental for 3 years and then primary for 2 years) -- gain prorated for 3 years of rental time.

I originally referenced this article that explains it well and has a nice example. (Note: I have no affiliation to and not promoting this firm - just like the article :)

http://www.goldentax.com/4838/A-Twist-For-Home-Sal...

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