If you convert your home to a rental property, and then sell the property, you might still be able to take a Section 121 exclusion on some of the gain. Show The Section 121 exclusion is available to homeowners who have owned and lived in the home at least two years out of the five years leading up to the date of the sale. What if you convert the property to a rental? ExampleYou own a house which you bought for $200,000. You move out of it but are unable to sell it, so you convert it to a rental property. Two years later you sell the property for $250,000. Rental property is depreciated over 27.5 years because the IRS says so. $200,000 / 27.5 = $7,273 per year x 2 years = $14,546 depreciation. As in my last post, I am not accounting for pro-rated depreciation in the first and last years for the sake of keeping the example cleaner. So when you sell the home, your gain is based on an adjusted basis of $200,000 – $14,546 = $185,455. The gain would be $250,000 – $185,455 = $64,545. The gain attributed to depreciation is $14,546. Because you meet the two-out-of-five rule, you can exclude all of the gain EXCEPT the depreciation. So you can exclude $64,545 – $14,546 = $49,999 (due to rounding, it’s not a nice clean $50,000). You’d need to claim the depreciation as income, so $14,546. This would be “Section 1250” gain, just like in our home-office example, and subject to taxation as ordinary income up to a maximum rate of 25%. ReportingUse Form 4797 to report the rental sale. You’ll use Part III on page 2 to report the full sale showing a gain, in full, of $64,545. Then in Part I of Form 4797, you’ll notate “Section 121 exclusion” and subtract out $49,999 of the gain. WarningsYou must meet the two-out-of-five rule on ownership of the home and usage as a primary residence. This means, when you move out, there’s a window of time (the next three years) where this method works. Otherwise you’re ability to take a Section 121 exclusion is gone. Also, this only works when you have a home you covert to a rental property. Going the other direction, from a rental to a primary residence and then selling, opens up far more complications involving “qualified” and “non-qualified” usage.  What Is The Tax Treatment When You Sell a Personal Residence That Had Been Converted From Your Principal Residence Into Rental Property? When you sell rental property that had once been your principal residence, tax treatment can get a bit complicated. In particular, you need to pay attention to the issues of losses, depreciation, and adjusted tax basis. You cannot deduct any loss you realize upon the sale of a home used wholly as your primary residence or second home. However, if the home is converted to rental use prior to the sale, you may be able to deduct a portion of the loss. How Do You Compute The Tax Basis of a Personal Residence Converted to Rental Property? In general, the adjusted tax basis of a personal residence is the cost of the property (i.e., what you paid for the property when you first purchased it), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes. (Improvements add value to the home, prolong its life, or adapt it to a new use. Note that regular repairs and maintenance are not included in the adjusted tax basis of the home.) When a personal residence is converted to rental property, you need to know its basis for depreciation purposes. Its basis for depreciation purposes is the lower of:
What Depreciation Method Is Used? Federal law provides that any real property acquired before 1987 and converted to rental or business use after 1986 is subject to the Modified Accelerated Cost Recovery System (MACRS). In general, you must depreciate your residential rental property over a 27.5-year period.
How Do You Calculate The Capital Gain or Loss on The Subsequent Sale of Converted Property? In order to calculate the capital gain or loss when you sell a residence that had been converted to rental property, you need to know three things:
If the converted property is later sold at a gain, the basis for purposes of determining the capital gain is your adjusted tax basis in the property at the time of the sale. If the sale results in a loss, however, basis is the lower of the property's adjusted tax basis at the time of the conversion or the fair market value when the property was converted from personal use to rental property. This loss rule ensures that any deflation in value occurring while the property was held as a personal residence does not later become deductible upon your sale of the rental property, a loss on the sale of a personal residence is not deductible. As usual, you calculate your capital gain by subtracting your adjusted basis from the sale price of the property. Example(s): Assume Ken converted his personal residence to income-producing property ten years ago. The house had an adjusted tax basis of $50,000 and was worth $60,000 when it was converted to rental use. Over the 10-year rental period, Ken deducted a total of $9,000 in depreciation expense. Ken sells the property for $65,000. His capital gain is computed as follows:
Caution: You’re holding period for converted property (for purposes of capital gain or loss) begins on the date that your property was acquired--not on the conversion date. This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867. The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process. The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.
Tags: Financial Planning, Lump Sum, Pension, Retirement Planning Can you avoid depreciation recapture?Investors may avoid paying tax on depreciation recapture by turning a rental property into a primary residence or conducting a 1031 tax deferred exchange. When an investor passes away and rental property is inherited, the property basis is stepped-up and the heirs pay no tax on depreciation recapture or capital gains.
What happens to passive activity losses when property is converted to personal use?What happens to the passive loss carryovers from our rental property if we change the property from rental to our primary home? Generally, disallowed passive losses may be carried forward to the next tax year (Sec. 469(b)).
How does depreciation recapture work?“Depreciation recapture” refers to the Internal Revenue Service's (IRS) policy that an individual cannot claim a depreciation deduction for an asset (thereby reducing their income tax) and then sell it for a profit without “repaying the IRS” through income tax on that profit.
What is the basis of property converted from personal use to business use?If you convert personal property to business use, the basis will be the lower of: the fair market value at the time of the conversion, or. the cost plus any additions or improvements, and minus any deducted casualty losses, up to the time of the conversion.
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Primary residence converted to rental property then sold
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