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If you own a rental property, you may have heard of the ‘trick’ to convert a rental property to a primary residence to take advantage of the $250/$500 K capital gains exclusion. It sounds too good to be true, right?
It could be.
While it’s legal to convert a rental property to a primary residence and take the capital gains exclusion, there are many things to consider before taking it. You may not be eligible for the full capital gains exclusion for starters, but if they follow the rules, most people can exempt some of the profits.
Here’s what you must know.
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What Is a Capital Gains Exclusion?
The capital gains exclusion applies only to your primary residence - the home you live in full time. When you sell your full-time home, you can exempt the first $250,000 for single-filers and $500,000 for married filing jointly filers from taxes.
But how do you figure your capital gains?
It’s more than just the sales price minus the price you paid when you bought the home. It’s the sales price minus costs incurred to sell the property.
These costs lower your sales price (and your taxes owed).
Your cost basis is the cost to buy the home plus closing costs, plus any closing costs, capital expenditures to renovate the home, minus depreciation minus insurance payments from any claimed losses.
The difference between the adjusted sales price and the cost basis is your capital gains. If your capital gains exceed $250,000/$500,000, you’ll owe taxes on the amount above the threshold.
Who Qualifies for the Capital Gains Exclusion?
To keep it simple, only those who have lived in the property full time for at least two years can claim the capital gains exemption. It doesn’t matter if only one spouse owns the home, though. Both spouses must live in the property full-time to take advantage of the exemption.
If you don’t satisfy the use test, meaning you didn’t live in the property full-time for an entire two years, you may be eligible for a prorated exclusion. This only applies if you moved due to employment changes, health reasons, or a divorce.
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Is There a Capital Gains Exclusion for Rental Properties?
Unlike primary residences, rental properties don’t have a capital gains exclusion. So if you rent the property out, or even if you don’t, but you don’t live there full-time, you can’t take the exclusion. However, you may be able to convert your rental property to a primary residence and accept the exclusion.
What Happens When You Convert Your Rental Property to a Primary Residence?
If you have a rental property that you convert to a primary residence, you may be eligible for a capital gains exclusion, but not on the entire amount of capital gains.
First, you must satisfy one rule.
You must live in the home for at least two of the last five years. They don’t have to be consecutive, but you must occupy the property as your primary residence for a total of 24 months.
For example, you bought a home in 2010 as an investment. You held onto the property and rented it out. In that time, you were able to take $43,000 in depreciation deductions since it was a rental. In 2015, you moved into the home and lived there until 2018, when you decided to sell the property.
You bought the home for $300,000, and in 2018 when you sold it, you were able to get $450,000. Without considering any other costs, you had $150,000 in capital gains. This is below the $250,000 threshold for single-filers, so you should be able to take the total exemption, right?
To prevent investors from continually buying investment properties and then comforting them to a primary residence for the capital gains, the IRS allows a prorated exclusion for the total time you owned the home.
In our example above, you owned the home for eight years. Of those eight years, you rented it for five years and lived in it for three years. Therefore, your exemption will be ⅜ since you lived in the property for three of the eight years you owned it. The remaining time is what they call ‘non-qualifying’ use.
This means you could exclude $56,250 from the capital gains but pay taxes on the remainder plus the depreciation recapture of $43,000.
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Understanding Depreciation Recapture
When you rent out a property, you should be able to take a depreciation deduction. Most investors can divide the property’s purchase price by 27.5 years and take the annual depreciation.
But when you sell the property, Uncle Sam wants his portion of the depreciation back. You’ll report the depreciation deductions on Schedule D of your tax returns and pay 25% tax on them.
In our example, you had $43,000 in depreciation, which means you’d owe $10,750 of it in taxes.
Taking Tax Deductions as a Homeowner
Once you live in the property as your primary residence, you lose some of the tax deductions you could take when it was an investment. This includes the depreciation deduction, repair costs, travel costs, and any other deductions you could take when the home was a ‘business’ and not a place for you to live.
The good news, though, is that you can take other tax deductions as a homeowner if you itemize your deductions.
You may be able to deduct:
- Mortgage interest paid
- Real estate taxes paid
- Mortgage insurance premiums
However, the amount you deduct must be prorated if you rented the property out for any part of the year.
Remember, you can only deduct expenses from a primary residence if you itemize your deductions. Therefore, if your deductions are less than the standard deduction, you should take the standard deduction and not worry about the deductions for owning a home.
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Can You Convert Your Rental Property Into a Primary Residence?
You can convert a rental property into a primary residence, but several things will change. Not only will you not be eligible for certain tax deductions, but you may also be able to save money on your mortgage and homeowner’s insurance. When you live in the property yourself, it’s less risky for insurance companies and mortgage lenders. They often provide more attractive rates and premiums for primary residences.
Is It Legal to Move Back Into Your Rental Property to Get the Capital Gains Exclusion?
It’s legal to move back into your home, converting it to a primary residence, but you won’t be able to take the full capital gains exclusion. It’s legal because you can only take a prorated exclusion based on the time you lived in the home as your own versus the time you rented the property to others.
Do You Have to Live In the Property for Two Consecutive Years?
The IRS doesn’t require you to live in the property for two years in a row to get the capital gains exclusion. However, you must live in the property for a full two years to receive it. So the longer you live in the property, the larger percentage of capital gains taxes you’ll be able to exclude.
Can You Sell a Rental Property and Not Pay Taxes?
There are a couple of ways to decrease your tax liability when selling a rental property. You probably won’t be able to eliminate taxes altogether, but you can reduce the amount you owe. Here’s how:
- Convert the rental property to a primary residence and live there for at least two years
- Use the 1031 like-kind exchange rule and use the funds earned from the sale to buy another investment property (receiving no cash in hand)
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If you converted a rental property to a primary residence, it’s important to know the rules. Working with a tax advisor is key to ensuring you follow the law but still get the tax deductions and exclusions you’re entitled to receive.