You want to sell your primary residence, but you rent part of it and don’t know how that affects your taxes. Or you’ve converted your residence to rental property or vice versa. How will you be taxed on the sale of the property? Here are various situations you may find yourself in.
Sale of a Primary Residence
The tax code recognizes the importance of home ownership by providing certain tax breaks when you sell your home. Under IRC 121 you may be eligible to exclude up to $250,000 gain (or $500,000 if you’re married filing jointly). To qualify for these breaks, your home must meet the eligibility tests:
- You owned the home and used it as your main home during at least 2 of the last 5 years before the date of sale. (“Principle Residence”)
- You didn’t acquire the home through a like-kind exchange (also known as a 1031 exchange), during the past 5 years.
- You didn’t claim any exclusion for the sale of a home that occurred during a 2-year period ending on the date of the sale of the home, the gain from which you now want to exclude.
In order to meet the Principle Residence requirement, the IRS uses a “facts and circumstances” test. This can come into question where the taxpayer owns more than one home. The question then becomes which property is considered to be your principle residence. The most important factor in determining principle residence is where you spend the most amount of time. Another factor is the address listed as your mailing address with USPS, on your diver’s license, and your federal and state tax returns. Finally, the IRS will determine whether your home is near your work, where you bank, proximity to one or more family members, and near recreational clubs or religious organizations of which you are a member.
What if you did not reside in the home for at least 2 of the past 5 years? You may still qualify for a partial exclusion of gain if you moved because of work, health, or an unforeseeable event.
Sale of Rental Property
When you sell rental property, you pay tax on any gain. If you have a loss, you are able to deduct the loss (unlike with a personal residence). The gain is typically reported on Form 8948 and Schedule D as capital gain/loss. However, any depreciation allowable must be recaptured as ordinary income on Form 4797.
While there is no Section 121 gain exclusion for rental properties, there are several ways to reduce or eliminate your tax exposure when selling a rental property:
- Offset your gains with losses (aka tax loss harvesting). The IRS allows you to combine gains with losses from unrelated activities to reduce your tax liability. For example, if you have $100,o00 capital gain from the sale of your rental property and lost $100,000 in the stock market that year, you can offset the gain with the loss, resulting in a wash.
- Using Section 1031 of the IRC. This section of the tax code allows investors to take the proceeds of a sale and reinvest them without having to realize any gains. This is referred to as a “like-kind exchange“. Essentially, you are swapping your rental investment for another. There are very important timing rules for such transactions. Investors have 45 days from the date of sale to identify potential replacement properties and 180 days to close on the exchange property. And if your tax return is due before the 180 days, you may have to close even sooner.
- Convert your rental property into your primary residence. By converting the property into your primary residence, you can take advantage of the $250,000 ($500,000 for married filing jointly) gain exclusion. The amount of your deduction will, however, be limited depending on how long the property was used as a rental property.
Sale of a Rental Property Converted from a Primary Residence
It was common during the downturn in the real estate market for homeowners to convert their residence into a rental property when they were not able to sell the home for a reasonable price. In such cases, it is possible to still qualify for a Section 121 exclusion where the homeowner used the property as a personal residence in at least 2 out of 5 years. For example: a property is used as a personal residence in 2010 and 2011, then converted for rental use in 2012 and 2013, and finally sold in 2014. The property would qualify for gain exclusion under Section 121; however, the gain will be reduced to the extent of any depreciation allowable during the rental use period.
Sale of a Primary Residence used Partially as a Rental Property
Some homeowners may have rented part of their home while using the remainder as their primary residence. The application of Section 121 will depend on two factors:
- State of separation. If your entire property, both the space you occupy and the space you rent, could function as a single property: if, for example, you converted your basement into an in-law suite but have access to either space by an interior staircase, then the entire property could qualify for the tax exclusion. However, if you must exit your portion of the residence to access the rented space, the IRS considers the rented space a separate, nonresidential property, and gain received for this portion of your sale cannot be excluded from gross income.
- Length of ownership and use. To qualify for the home-sale exclusion, you must also have owned the property for the five years prior to its sale, and you must have used that home as your primary residence for at least two of those five years. What if you don’t meet both requirements? Well, there’s still time. Time to rebuild the staircase you tore down. Time to replace the door and frame you filled in with drywall. Time to remove any barriers between the two spaces. And time to occupy your newly configured residence for at least two full years. Special rules would apply, and the total gain on the sale of your home would be adjusted according to the amount that you depreciated your rental space, but you could still benefit from the changes.