Converting primary residence to rental property capital gains

Did you know that you can avoid paying tax on more than $500,000 of gain on your home? Many people are aware of the advantages of Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence ($250,000 for a single taxpayer). Although this amount of gain is generous in most areas of the country, in some states homeowners receive more than $500,000 of profit when they sell their home.  That additional profit is subject to federal and state capital gains tax and net investment income tax (Medicare tax).

What is much less understood in the real estate world is that a homeowner can avoid paying all of the tax on their home by converting it to a rental. Once the home is converted to a rental, the owners can sell it and use both the Section 121 exclusion of gain and the Section 1031 deferral of gain provisions to exclude some of the gain and defer paying tax on the rest.  Most tax advisors recommend renting the home for at least two years to establish it as a rental, but if you rent it for too long, you could lose the ability to benefit from the Section 121 exclusion, since that provision requires that you have lived in the home as your primary residence at least two of the past five years. 

For example:

John and Mary Smith have lived in their home for twenty years. They acquired it for $100,000 and it is now worth $1 million, so if sold, they would have $900,000 of gain. If they sell it without converting it to a rental, they would be able to exclude $500,000 of gain but would have to pay capital gains tax on the additional $400,000 of gain.

John and Mary decide, however, to convert their property to a rental. After renting it for two years, they sell it for $1 million. Since they used the home as their primary residence at least two of the past five years, they are able to exclude $500,000 of the gain. They can then use the remaining funds to acquire replacement investment property in a 1031 exchange and defer paying tax on the balance of the gain.  In order to accomplish this, they must set up the 1031 exchange prior to closing on the sale of the property. 

In order to completely defer the remaining gain, the traditional rule is that the investor must acquire replacement property with a fair market value equal to or greater than the relinquished property, and must invest all of the equity from the relinquished property into the replacement property. When gain has been excluded under Section 121, however, the amount of value and equity required to invest in the replacement property is reduced by the amount of gain that was excluded under Section 121. 

Homeowners who decide to combine a sale of their primary residence with a 1031 exchange need to comply with all of the rules of Sections 121 and 1031 in order for this to work. Revenue Procedure 2005-14 explains how the two statutes may be combined for one property. This ruling includes not only the situation mentioned above, but also a sale of a personal residence with a home office or separate guest house that is rented.

Some of the requirements to keep in mind are:

• To take advantage of the $500,000 exclusion ($250,000 for single Taxpayers), you must own and live in your home as your primary residence at least two of the past five years;
• You can only take advantage of the Section 121 exclusion once every two years;
• Section 121 doesn't allow you to exclude any gain attributable to depreciation deductions taken since May 6, 1997, but that gain can be deferred under Section 1031; and
• To take advantage of the deferral of gain under Section 1031, the property you sell and the property you acquire must at the time of the exchange be used in connection with your business or held for investment.

This article discusses some general concepts, but you should consult with your tax advisor and contact First American Exchange Company to set up your tax deferred exchange.

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Renting out your personal residence for a short period or converting it into a rental property can raise federal income tax issues.

With the rise of companies offering vacation rentals online, such as Airbnb and Vrbo, the idea of converting a primary residence into a rental property sounds easy enough. This conversion can help bring in additional income along with some other tax benefits. But before taxpayers start diving into the rental business, they need to understand what’s required to turn their primary residence into a rental as well as the issues they may face during this conversion and the possible reconversion back into residential.

They also need to be aware of the tax implications of offering their property as a rental for a brief period before the sale of their personal residence.

A taxpayer may rent their primary residence for a short period with no tax consequences. For instance, under Internal Revenue Code (IRC) §280A(d)(1), the taxpayer doesn’t need to record any income or expenses associated with the rental if the residence is rented for 14 days or less during the taxable year. Likewise, if the residence is rented for a period of less than 12 months before it’s sold, it isn’t considered a rental activity to earn a profit (IRC §280A(d)(4)).

RULES FOR CONVERSION

If a taxpayer decides to convert their residence into a rental property, expenses must be prorated to reflect the rental period during the year of conversion. They need to depreciate the property once it becomes a rental property, and if the taxpayer also lives on the premises, the depreciation must be prorated by the portion that’s being used for rental purposes rather than by the whole building.

The three factors that the taxpayer must remember when determining how much to depreciate each year are (1) the tax basis in the property, (2) the recovery period (how long the building is expected to last) for the property using the Internal Revenue Service (IRS) cost-recovery tables for residential rental property, and (3) the depreciation method that will be used (see IRS Publication 527). Mortgage or principal payments and the cost of furniture, fixtures, or equipment can’t be deducted as an expense.

To determine the basis of the converted property, the taxpayer must use the lesser of fair market value (FMV) or adjusted basis on the date of conversion. The adjusted basis is viewed as the acquisition costs less any adjustments such as rebates and depreciation. Taxpayers must decrease the basis of their property by any items that represent a return of their costs. These items include insurance, residential energy credits that were allowed before 1986 or after 2005, and depreciation that has been or could be deducted.

It’s important to realize that even if the taxpayer elects not to take depreciation in any year when the property is being rented, the adjusted basis of the property is still reduced by that amount (i.e., use it or lose it). The taxpayer must stop depreciating the property when the total of their yearly depreciation deductions equals the cost or other basis of the rental property.

The rules for depreciating personal rental property are slightly different from the rules for commercial buildings. The depreciation amount is calculated by first determining the basis of the property, which is usually the lesser of its adjusted basis or its FMV at the point of its rental use, and then using the modified accelerated cost recovery system (MACRS) percentage table to determine the depreciation expense for each year of service (IRS Publication 527).

Let’s look at an example: A taxpayer buys a house for $160,000 and uses it as a personal residence for several years before converting it into a rental property in February of the year of conversion (second month of the year property placed in service). At the time the house is converted into a rental, its FMV is $200,000. The basis for depreciation is $160,000 (lower of cost or market), and the depreciation deduction (under MACRS and 27.5 years (IRS Publication 527)) for the first year of rental is $5,091 ($160,000 x 0.03182). As an aside, if the rental property is sold after the first year for $140,000, the taxpayer can claim a loss of only $14,909 ($160,000 ‒ $5,091 = $154,909, so the adjusted basis is $140,000).

RULES FOR RECONVERSION

If the taxpayer decides to retire the property from rental and convert it back into residential, there are a few challenges. First, the current adjusted basis needs to be reestablished. If the FMV was equal to or greater than the adjusted basis of the property when it was converted to rental, then the current adjusted basis would be carried over to the converted residential property. If the FMV was less than the adjusted basis at the time it was first converted to rental (unusual but possible), then the current adjusted basis must be calculated to account for the lost adjusted basis at the time of conversion. That is, any adjustments to basis for depreciation end on the date of the reconversion into residential property.

Second, if the taxpayer elects to sell the reconverted residential property, they may be able to use part of their $250,000 ($500,000 if married filing jointly) gain exclusion. If during the five-year period ending on the date of the sale the property has been owned and used as the taxpayer’s principal residence for periods aggregating two or more years, the taxpayer needs to calculate the gain allocable to the percentage of residential ownership and the percentage for the rental period.

Let’s look at an example: A taxpayer has owned and used a house as their principal residence since 2018 but then moves out and decides to rent the property in 2020 before selling it in 2022. The taxpayer is eligible for the gain exclusion because the house has been owned and used as their principal residence for at least two of the five years preceding the sale.

Converting a primary residence into a rental property sounds like an easy process, but to get the most out of the tax benefits, taxpayers must pay close attention to how they participate in the rental property, how they depreciate it, and how they account for any profit or loss on the property. Taxpayers must remember to prorate expenses and depreciation from the day of the conversion and maintain proper documentation along the way to make filing their taxes at the end of the year much easier.

© 2022 A.P. Curatola

Marissa Amarante is the Vertex Fellow at Drexel University. Marissa can be reached at .

Anthony P. Curatola, Ph.D., is editor of the Taxes column for Strategic Finance, the Joseph F. Ford Professor of Accounting at Drexel University, and a member of IMA’s Greater Philadelphia Chapter. You can reach Tony at .

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