Primary to Rental to Primary Tax Implications

3 Replies

Hi, 

I'm looking for clarification on the following scenario:

I buy and live in a house as my primary residence for 2 years. Then, I convert it to a rental for the next 5 years. Finally, I decide to return and change the rental back to my primary residence for 2 more years. I subsequently sell the house and have capital gains of $100K. 

Under this scenario, am I exempt from paying capital gains tax on the $100K? Or would I have to pro-rate it based on number qualified vs non-qualified use? 

@Robert Wong If you move back into your rental and convert it to a primary residence and live there for at least two years you will be able to qualify for the 121 Exclusion. The Exclusion allows you to sell your primary residence and exclude from gross income up to $250k for a single taxpayer and $500k for a married couple. You must have owned and lived in the property as your primary for at least a total of 24 months out of the last 60 months. Since the previous three years were a rental the Exclusion will be prorated. The proration is calculated based on the number of years the property was used as your primary.  Therefore, the longer you use that property as a primary the more exclusion you will receive.

Hi @Robert Wong - welcome to Bigger Pockets

I am assuming that none of the $100,000 in capital gains in your scenario are due to a depreciation adjustment to basis.

In the scenario you outline, under Section 121b5 you had 4 years of qualified use (when you lived in the house) and 5 years of non-qualified use (when you rented it). Therefore, 4/9 of your $100,000 gain qualifies for the section 121 exclusion ($44,444). (And you actually use months or days, not years, when performing the caluclation.)

Note that the non-qualified use is created when you convert from business property to primary residence. If you were to buy a house, use it as a primary residence for 2 years then use it as a rental for 2 years, then sell it you could get the full section 121 exclusion for capital gains. In this scenario you never went from a business back to primary residence, so no period of non-qualifying use was created.

Best of luck with your real estate investments!

@Robert Wong , You prorate and you also have to recapture all depreciation from times of non-qualified use.  

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