If you have a rental unit that has a substantial amount of
equity you may be able to take advantage of the Home Sale Exclusion if you lived
in the house at any time before it is sold.
However, before you move ahead there are a number of tax consequences
that you need to be aware of.
Limits on
Home Sale Exclusion
You have heard of the tax law that allows owners a
$250,000/$500,000 home sale exclusion on any gain that is made. This rule
permits single homeowners to exclude from their taxable income up to $250,000
in profit realized from the sale of a personal residence. The exclusion is
$500,000 for married couples filing jointly. There is no limitation on how many
times the exclusion may be used during your lifetime. Generally, you can use
the exclusion every two years.
To qualify for the home sale exclusion, you must own and occupy
the home as your principal residence for at least two years before you sell it.
Your two years of ownership and use can occur anytime during the five years
before you sell—and you don’t have to be living in the home when you sell it.
However, a special rule enacted in 2009 limits the
$250,000/$500,000 exclusion for homeowners who initially use their home for
purposes other than their principal residence, such as a rental or vacation
home. The rule requires you to reduce pro rata the amount of profit you exclude
from your income based on the number of years (the IRS worksheet calculation
actually uses the number of days) after 2008 you used the home as a rental,
vacation home, or other “nonqualifying use.”
Example: John buys a home on January 1, 2009 for $400,000, and
uses it as rental property for two years. On January 1, 2011, he evicts his
tenants and moves into the house, thereby converting it to her principal residence.
On January 1, 2013, he moves out and rents it again. He then sells the property
for $700,000 on January 1, 2014. He has a $300,000 gain (profit) on the sale. John
owned the house for a total of five years and used it as a rental property for
two years before he converted it to her residence. Thus, two of the five years
(40%) before the sale were a nonqualifying use, so 40% of his $300,000 gain
($120,000) does not qualify for the exclusion. This means that he must add
$120,000 to her gross income for the year. His remaining gain of $180,000 is
less than the $250,000 exclusion, so it is excluded from his gross income.
A nonqualified use can occur only before the home was used as
the taxpayer’s principal residence. Time periods after the home was used as the
principal residence do not constitute a nonqualified use. This is why John’s
nonqualifying use during 2013 does not reduce her exclusion.
Recapture
of Depreciation Deductions
Converting a rental into your residence will not eliminate all
taxes when you sell it. While the home was a rental, you should have claimed a
depreciation deduction for it each year. The total amount of depreciation you
claimed during the rental period is not eligible for the exclusion. Instead,
you must "recapture" all your depreciation deductions--that is report
them on Form 1040 Schedule D and pay a flat 25% tax on these
deductions. This can have a significant tax impact. In the example above, if
John had taken $10,000 in depreciation deductions during the time he rented out
the home, he would have to pay a deprecation recapture tax of $2,500 (25% x
$10,000 = $2,500).
Ownership
Taxes and Deductions
Once you occupy the home as your personal residence, you will no
longer be able to take any of the deductions you took when the property was a
rental. This means you will get no depreciation deduction and you can't deduct
the cost of repairs. However, you will be entitled to the deductions provided
to homeowners--that is, you may deduct a personal itemized deduction on Form
1040 Schedule A the amount of your mortgage interest, mortgage insurance
premiums, and even property taxes. The expenses must be prorated for the time
the home was not considered a rental property.
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