I know I can ask my tax accountant, but wanted to get a general feel for what I am thinking of doing.
This home was my primary residence for 3+ years then it became a rental for the past 1.5 years.
How does the capital gains tax work? This is in case I decide to NOT use a 1031 exchange, which is still an option. But if I simply want to cash out my profits, how much is taxable?
Provided you owned the property at least two of the five years prior to sale AND occupied the property as your primary residence at least two of the five years prior to sale, all of your sale profit up to $250K per taxpayer can be excluded from capital gains taxes. The tax on unrecaptured depreciation during the rental period is still payable and can not be excluded. Unfortunately, any tax loss you incur on the sale of a primary residence is not deductible.
Once you no longer meet the two of five year ownership and occupancy tests, 1031 exchange becomes an advantageous option, but probably not before.
Someone please correct me if this is wrong, but my understanding is that your cost basis is not the price you purchase the home for, but rather the market value of the home at the time you converted it to a rental (and then less any depreciation over those 1.5 years).
If you purchased at $200,000, and it was worth $230,000 when you started renting it, and you sold it for $245,000 now, then I believe you would pay capital gains tax on a gain of $15,000. That's not factoring in depreciation recapture, which will cause additional tax.
(Clearly) I am not an accountant.
Ordinarily, you would be right, but only if the FMV value is less than the adjusted cost basis. If the FMV is greater than the adjusted cost basis at time of conversion to rental use, then the tax basis is not adjusted. Depreciation basis for the period of rental use would also be determined by the lower of the FMV or the adjusted cost basis at the time of conversion to rental use.
I see. So it can be adjusted against you, but not in your favor? Sounds fair :)
Providing the property is selling at a profit after just 4 years of ownership, resetting the tax basis a bit lower is unlikely to exceed the $250K §121 exclusion.
@Dave Toelkes I just saw your first post... duh, can't believe I didn't think of the 2/5 year primary home exemption. Glad someone smarter than me is posting here :)
@Jackie F. , In your situation you would get to take the first $250K of gain ($500K if married) tax free. You will have to recapture depreciation taken during time as a rental unless you also do a 1031 exchange at the same time. It is certainly possible to combine a primary residence exclusion and a 1031 exchange to completely eliminate most and defer the rest of the tax.
However in your case with only 1.5 years of depreciation it might make more sense financially to simply forgo the 1031 portion and pay the depreciation recapture. All depends on that amount since you'll want to offset that off the price of an exchange - probably $750
That's great news. So I am in the clear for most of the capital gains and only have to pay taxes on any depreciation. As along as I meet the 2 of 5 rule. I will discuss this with my accountant in a few weeks and then decide how to proceed. I am working with a 1031 exchange now and it is very constrained. I am not enjoying the process but am happy I have an opportunity to sell one of my previous homes without having to deal with a 1031.
Thanks to everyone. Great feedback.