IRC section 121(b)(4)(C)(ii)(I) allows taxpayers to ignore any nonqualifying use that occurs after the last date the property was used as a primary residence, though the 2-of-5 ownership-and-use tests must still be satisfied. We are planning on retiring to Utah, but don’t want to pay tax on this $500,00… The related rental activity was the taxpayer’s only passive activity for purposes of Sec. Since there are only 2 years of qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. Or Reach Michael Directly: Continuing education that actually teaches you something. Property Rental conversion to Primary Residence and Back to Rental Property I have a rental property that has about a $60K loss carry over. Donna has lived in her property as a primary residence since 2008. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion. Join 41,901 fellow financial advisors getting our latest research as it's released, and receive a free copy of The Kitces Report on "Quantifying the Value of Financial Planning Advice"! info@otcpas.com, 300 Prairie Center Dr., Ste. For clients that are more active real estate investors, there may be significant appeal to more proactively taking advantage of the primary residence exclusion rules, notwithstanding the limitations on nonqualifying use, especially in light of the fact that gain is always assumed to be allocated pro-rata across all the years, and not necessarily based on when gains actually occurred. What happens if you sell your Principal Residence at a gain that has suspended Passive Activity Losses from the rental period? He originally paid $320,000 for the property, the assessed value of the land was $40,000 and the home was $280,000. The IRS concluded in a Chief Counsel Advice memo (CCA) that excluded gain from the sale of a former principal residence that was converted Property owners with modified adjusted gross incomes of $100,000 or less may deduct up to $25,000 in rental real estate … If Donald sells his current house, and moves into the rental property now to make it a new primary residence and sells it in 2 years for $775,000, the total gains above original cost will be $375,000. The primary residence exclusion can therefore potentially apply to a capital gain or loss on disposal of such shares if the residence is used as a primary residence. Under Sec. A’s $100,000 of gain from the sale of the property is excluded from A’s gross income as provided under IRC 121. Deductibility of Rental Losses We have owned a rental home in Paradise Valley, Arizona for eight years. When a taxpayer generates a loss, it generally either offsets other sources of income and therefore reduces the amount of tax that otherwise would be paid, or may even produce a net loss that in some instances can generate a refund of taxes previously collected. The taxpayer bought a home for $700,000 and owned and used the residence as his principal residence for two years. He will still have 4 years of nonqualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use (2000-2008 inclusive, and 2013-2016), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed nonqualifying use capital gains and subject to taxes (in addition to any depreciation recapture). In addition, any depreciation recapture since 2000 would still be taxed as well. Want to know how to explain what your advice is worth? The Chief Counsel Advice described a scenario in which a taxpayer bought a principal residence for $700,000 and owned and used it as his principal residence for two years before converting it into a rental property. To limit this, American Jobs Creation Act of 2004 (Section 840) introduced a new requirement (now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange. @Dimitri Carso, you're still falling under the primary residence exclusion of sec 121.You can do this but your tax free portion will be limited. A taxpayer may decide to permanently convert a personal residence to rental property. The exclusion is $500,000 for married couples filing jointly. To prevent abuse of this planning scenario, Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “nonqualifying” use. Simply stated, the passive loss carryover can only be used in years in which the unit is a"rental only" property to offset income from passive activities; the Sec. Tax Consequences of Converting a Rental Property Back Into a Dwelling. 469. If you've been investing in real estate, capital gains issues might be even more important to you than itemized tax deductions. During each year that the property was rented, it produced $10,000 net losses that were disallowed as passive losses under Code Sec. Max and Jenny, a married couple, bought a home decades ago for $250,000, and are now selling it for $900,000. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). Q: I have a rental house that my wife and I are planning to make my primary residence. Example 4. 651-483-4521 | 800-866-4521 Donald purchased a rental property in early 2009 at the market bottom for $400,000, and it has appreciated in the 5 years since to $750,000. However, for those who also invest in rental real estate, the capital gains exclusion on the sale of a primary residence creates an appealing tax planning opportunity – to convert rental real estate into a primary residence, in an effort to take advantage of the capital gains exclusion to shelter all of the cumulative gains associated with the real estate. If the property was sold for an amount in between $440,000 and $480,000, there would be no tax gain or loss on the sale. In 2012, she received a new job opportunity across the country, but decided she didn’t want to sell the property yet as home values were still recovering in her area, so she rented the property instead. Converting the property from the rental back to your primary residence does not qualify as “disposing of the property.” Thus, the losses you incur each year, relative to your rental property, will most likely not yield a … … The taxman doesn’t want people to erase the taxes on an investment property simply by converting the property to a primary residence, so some rules … Dexter converted his primary residence to a rental property. This may include having clear documentation to show exactly when the property was used as a primary residence (especially if it may not be the full 2-year period and the pro-rata partial exclusion may apply, or if there are periods of qualifying and nonqualifying use), and also planning around using the exclusion in the event of death or divorce of a spouse (in both situations, ownership and use of a deceased spouse or an ex-spouse can potentially be ‘tacked on’ to the subsequent owner to qualify for the exclusion). 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