Sell rental before capital gains tax?

[Kelly Williams]

I am moving out of my current residence and plan on turning it into a rental. From what I can tell if I sell the house within 3 years after moving out, I will not have to pay capital gains tax. The rule is if you lived in the house 2 out of the last 5 years then no capital gains tax is needed, if the gains are under $500,00 which mine will be. So my question is, when does it make sense to keep the property as a rental longer than 3 years? I do not foresee keeping the property as a rental for more than 10 years, probably less. Any input?

[Bill Exeter]

There are two strategies that often get confused with one another. The first is when the investor owns rental property and decides to convert it into his or her primary residence (not the case here) and the second is when the investor owns a primary residence and decides to move out, convert it to rental property and ultimately sell it.

Rental Property to Primary Residence

@Steven Hamilton II description above is right on the money here. The taxpayer can cease to rent the property, move into it and convert it to their primary residence. If they 1031 Exchanged into the property, they must hold/own it for at least five years before they can qualify for the 121 Exclusion. If they did not 1031 Exchange into it, then the only have to live there for two (2) years in order to qualify for the 121 Exclusion.

When they ultimately do sell with the intent to take advantage of the 121 Exclusion, the capital gain will be "prorated" as Steve mentioned between the number of years the property was held as rental versus the number of years the property was held (and used) as your primary residence. The amount of gain allocated to the primary residence usage will be tax free up to the $250/$500,000 limit.

Primary Residence to Rental Property

@Dave Toelkes is right on the money here. If the property was always used as a primary residence, and the property owner decides to move out and rent the property, they owner has a three (3) window from the date he/she moves out to sell, close and qualify for the 121 Exclusion. The capital is not prorated in this case.

Also, the investor can also qualify for a 1031 Exchange in this case (Revenue Procedure 2005-14) as long as they can say they have owned and lived in the property as their primary residence for a total of 24 months out of the last 60 months AND the property has been rented out for a sufficient period of time to demonstrate they had the intent to hold for investment (generally 12 to 24 months). So, they could potentially receive tax free treatment for up to $250/$500,000 in gain and the balance (if any) would be deferred into another rental property via the 1031 Exchange.