Primary Home -> Rental -> Selling: Taxes and Tenants

[neo von retorch]

You may have noticed another thread where I'm trying to do some basic math to see if it'll be better for financial independence to own a mildly profitable rental property, or to sell it and just invest the proceeds. Of course, those calculations don't even take into consideration two tax hits:

• Depreciation recapture
• Capital gains

I have a few questions along those lines. I bought the property in 2007 and lived in it through most of 2014. I officially started renting it out, and listing a rental in my taxes as of September 2014. So while my understanding of tax law is limited, I imagine when I sell, deprecation recapture will be part of my tax bill. Does anyone have a good resource for better understanding that, or figuring out how to calculate it?

Similarly, a normal rental property sale will trigger capital gains. (I assume that's sale price minus purchase price, probably after all closing costs on both ends?) But if you own a property for more than five years, and live in it for more than two, you can sell it as your primary residence. I assume the law is clever enough to specify  when you live in it - i.e. the two years leading up to the sale. Is that the case?

Finally, I've read about this, but perhaps someone can better explain it to me. It sounds like the "easiest" option is to give the mandatory notice to the tenants and just sell the property once it is empty (after giving them the option to buy, which are offers I don't think will be accepted)? Are there any other (perhaps more palatable) options? Contract-wise, it won't be a giant issue. One of the tenants is already month-to-month. The other will be by spring, so I could give notice and start preparing for sale. (The third and final tenant is moving out early next month, and if I make this decision quickly, will not be replaced.)

[BiggerFishToFI]

Yes, depreciation recapture will be part of your due taxes when you sell. Not super familiar with how this works yet (but will be by next April....)

Regarding the 2 of 5 rule, there is no specification on when you lived at the property, just that it was your primary for 2 of the previous 5 years. So you can purchase a property, live in it for two years, then sell it and exclude capital gains (up to a max, I believe 250k for single filers and 500k for filing jointly). You can also purchase a property, live in it for 2 years, then rent it for just under 3 years. As long as you sell the property where you lived in it for 2 of the past 5 from the date of closing you can exclude the capital gains up to the limit

[bacchi]

Because you last lived in the property in 2014, it won't be considered a primary residence. You're selling a rental.

E.g., https://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2015/09/17/tax-implications-for-converting-a-primary-residence-to-rental-property

For recapture, add all of the past tax return depreciation amounts. In this case ^^^, the depreciation was $152,727. The gains taxed at the capital gains rate is 372,727 (profit on sale, based on adjusted cost basis) - 152,727 (depreciation) = $220k and the recapture tax is based on $152,727 as ordinary income (that's where it helped you in the first place).

[kenmoremmm]

Yes, depreciation recapture will be part of your due taxes when you sell. Not super familiar with how this works yet (but will be by next April....)

Regarding the 2 of 5 rule, there is no specification on when you lived at the property, just that it was your primary for 2 of the previous 5 years. So you can purchase a property, live in it for two years, then sell it and exclude capital gains (up to a max, I believe 250k for single filers and 500k for filing jointly). You can also purchase a property, live in it for 2 years, then rent it for just under 3 years. As long as you sell the property where you lived in it for 2 of the past 5 from the date of closing you can exclude the capital gains up to the limit

i don't think this is true anymore. 2 in 5 is no more. everything must be prorated. there is a cutoff point where anything that was a rental before a certain year will be treated as primary, so that helps. but for the OP, i don't think it matters. OP will have 4 years as rental and 11 years of ownership. therefore cap gains and depreciation recapture will be at 7/11 exclusion.

https://www.financialsamurai.com/tax-free-exclusion-needs-to-be-prorated-after-converting-long-term-rental-into-primary-home/

[BiggerFishToFI]

Yes, depreciation recapture will be part of your due taxes when you sell. Not super familiar with how this works yet (but will be by next April....)

Regarding the 2 of 5 rule, there is no specification on when you lived at the property, just that it was your primary for 2 of the previous 5 years. So you can purchase a property, live in it for two years, then sell it and exclude capital gains (up to a max, I believe 250k for single filers and 500k for filing jointly). You can also purchase a property, live in it for 2 years, then rent it for just under 3 years. As long as you sell the property where you lived in it for 2 of the past 5 from the date of closing you can exclude the capital gains up to the limit

i don't think this is true anymore. 2 in 5 is no more. everything must be prorated. there is a cutoff point where anything that was a rental before a certain year will be treated as primary, so that helps. but for the OP, i don't think it matters. OP will have 4 years as rental and 11 years of ownership. therefore cap gains and depreciation recapture will be at 7/11 exclusion.

https://www.financialsamurai.com/tax-free-exclusion-needs-to-be-prorated-after-converting-long-term-rental-into-primary-home/

2 of 5 rule still holds, but you do need to recapture any depreciation. Best to go straight to the source:

https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc-5

Agree that this doesn't help OP, he only meets 1 of 5 and fails the use test. He would need to move back in for two years to pass the use test.

[bacchi]

It looks like FS scenario #2 is wrong. Bob didn't shoot himself in the foot, after all.

"Eligibility Step 1—Automatic Disqualification" -- Bob's ok there
"Eligibility Step 2—Ownership" -- Bob's definitely the owner for 24 months.
"Eligibility Step 3—Residence" -- This is the tricky one, discussed below.
"Eligibility Step 4—Look-Back" -- Has Bob used the exclusion in the past 2 years? No, he hasn't.
"Eligibility Step 5—Exceptions to the Eligibility Test" -- No exceptions for Bob.


"Eligibility Step 3—Residence", explained

If you owned the home and used it as your residence for at least 24 months of the previous 5 years, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period, and it doesn'tt have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period.

Compare that eligibility rule with the FS scenario:

Bob bought his house in 2003 and moved in right away. He lived there until January 1, 2016, and started renting it out after that. But it’s mid-2018, and he’s worried he might not be able to sell it before January 1, 2019. So, to make sure he doesn’t fall short of the 2-out-of-5-years rule, he kicks his tenant out and moves back into the property on July 1, 2018.

In the previous 5 years, from 7/1/13 to 7/1/18, Bob lived in the house for 2.5 years (from 7/1/13 to 1/1/16). That meets the 24 month test, as FS notes, giving Bob until 1/1/19 to sell it and get the exclusion (1/1/14-1/1/16).

However, if the house is sold on 3/1/19, Bob still meets the 24 month test (3/1/14-1/1/16 + 7/1/18-3/1/19) and gets the full exclusion if he moved back in. The FS conclusion contradicts this:

If Bob continues to live in his old rental, then his prorated capital gains inclusion will continue to grow, but never back to 100%. For example, if he lived in the property until Jan 1, 2022 (for three more years) after moving in on July 1, 2018, his exclusion would be 16.5 / 19 years, or 87%.

If the eligibility requirements are met, then Worksheet 1 is used: https://www.irs.gov/publications/p523#en_US_2017_publink100077247

"You are eligible for the maximum exclusion if..."
"Both spouses meet the residence and look-back requirements and one or both spouses meet the ownership requirement."

Following the steps in 1.B) also agree with this (because the smallest period is 24 months, and its divided by 24 months, yielding 1 * $250k).

I think the confusion lies in the code, 121(a), "...for periods aggregating 2 years or more." Because the residence periods don't have to be contiguous, an owner can move back in at any time to reach 24 months.