Home converted to rental sale

[Tony Norella]

We are thinking about selling a home we own.  We lived it for 5 years and because we were under water on it, we couldn't sell it so we rented it out and bought another home.  We have rented it for 5 years now.  Is any profit on the sale excluded from capital gains?  or is it treated like a rental home and all profit is subject to capital gains?

[Bill Exeter]

Hi @Tony Norella, 

You have a three (3) year window from the date that you move out of the property in order to take advantage of the $500,000 tax free exclusion under Section 121 of the Internal Revenue Code.  You are now well past the three (3) year window, so it is merely treated as investment property at this point in time.  

You could sell and defer the payment of your taxes through a 1031 Exchange if you want to remain invested in property held for rental, investment or business use. 

You can trade down in value by buying a lower priced property, but any amount that you trade down by will be taxable, and if you trade down by more than your taxable gain you will realize all of your taxable gain and a 1031 Exchange would not provide you with any benefit.  You can buy multiple properties in order to make up the total reinvestment requirement if you like, too.  It does not have to be one sale and one purchase. 

Your intent must be to buy for rental or investment purposes, but years later your intent could change and you could convert the property into your primary residence later.  It all boils down to your intent.  I would personally make sure that you hold for rental purposes for at least 24 months, which would straddle three income tax years.