Capital gains exclusion in case of primary to rental to primary?

Question

Hi everyone. We have lived in our house as our primary residence for almost 6 years. If we move out, convert it to a rental for 3 years, and then sell it, any appreciation during all 9 years (including the period it was rented) would be eligible for capital gains exclusion, correct?

What if after those 3 years renting it out we decide to move back into the house and then a few years later sell it? Would all the capital gains also be included in this case?

For anyone curious: The reason this is possible for us is our house is small and we are outgrowing it. We like it an the neighborhood though, so we're considering moving to a new house while we expand this current one and rent it out at least long enough to meet the 2 year rule (2 our of 5 years for exclusion) in the interim house.

Thanks.

Michael Plaks · Answer

@Nick Brubaker @Bill Brandt got it right. Moving back screws up the exclusion, making it prorated.And it is designed this way intentionally. Otherwise, anybody could move into a highly appreciated rental for 2 years and kill the capital gains tax. The Congress says: not so fast!

Bill B. · Answer

In the first case as long as it was your primary 2 of the last 5 years then you’d only owe depreciation recapture for the 2 years you declare it while it was a rental. (Yes, you owe the taxes even if you don’t take depreciation, so take it.)You might have a problem If you move out, rent it and then move back in. You MIGHT trigger the same rule that kicks in if it’s a rental first, only the percent of time it was your primary would be tax free. (If you have a rental for 4 years then move in as a primary for 6 years it’s only 60% tax free.)If you do plan to move back in, talk to an expert but expect the only save a prorated portion of the taxes. The “expert” known as google says…https://www.merriman.com/wealt...Scenario 3 This is similar to Scenarios 1 and 2, except the couple buys the home on January 1, 2003 and then rents out the home for 10 years starting on January 1, 2005. They move back in full-time on January 1, 2015. They sell the property two years later on January 1, 2017, with depreciation of $70,000 over the rental period. As a result, the property’s adjusted basis is $305,000 ($375,000– $70,000 depreciation taken). The gain on the sale is $220,000 ($525,000 – $305,000). Since the couple meets the requirements to use the tax-free gain exclusion, we need to break down the gain based on qualifying use and non-qualifying use: Qualifying use– The home was their primary residence for four years out of the 14-year holding period. Also, four years of the 10-year rental period are considered qualifying use because they occurred prior to 2009 where all ownership is considered qualifying use for the purpose of this test. Therefore, eight years, or 57% of the gain is attributable to qualifying use and is eligible for the tax-free gain exclusion.Non-qualifying use– Six years of the rental period is considered non-qualifying use, so 43% of the gain is taxable. Of the $220,000 gain, the first $70,000 is subject to depreciation recapture at up to 25%. Of the remaining $150,000 gain (appreciation above the original basis), $85,500 ($150,000 × 57%) is considered qualifying use and is eligible for the home sale exclusion and is tax-free. 64,500 ($150,000 × 43%) is considered non-qualifying use and is subject to capital gains taxes.

Nick Brubaker · Answer

Thanks for the advice and taking the time @Bill Brandt I think the idea is we would rent out that house for the following 3 years as well, which would justify things more. But good point regarding selling costs and general opportunity costs.

Bill B. · Answer

Way beyond my expertise but seems unlikely to be a benefit. If you owned for 2 years and it went up 5% per year that’s 10% subtract 10% selling costs and you’ll be lucky to break even. Probably a smarter decision to rent for that year or two. what if prices stay even or go down 2%? Then add 10% selling costs and you’re out 12% of the purchase price plus how ever much more buying is than renting, plus and repairs.Do you have any empty nester family in town you could rent the basement from?I don’t think one person on BP would say buy a house you will be selling in 1-2 years and expect to profit. A CPA will have to weigh in on if declaring another home your primary causes “unqualified use” for your current home. IMHO. You’re risking 10’s of thousands to try to save 1,000’s at most in taxes. And all the income yoru downpayment coudl generate in a world where banks are paying 5% risk free.

Nick Brubaker · Answer

@Bill Brandt To continue this hypothetical tax discussion with a non-CPA : ) What if we buy a second house and make it our primary during that time? Would be nice if we made it to the 2 year mark on that property, but can't see a case where a project would be that big and where it would make sense to extend to 2 years just for the sake of the 2/5 rule. @Michael Plaks?

Bill B. · Answer

Nope. Says the non-cpa. :-). What’s the living plan during that time? This is all assuming this property remains your “primary home”. Imagine you went on a year long cruise and your home sat empty. Or spent a year taking care of a sick relative while the house sat empty if you didn’t make it a rental I can’t see the difference. Or it was damaged by a fire/tornado and there was a massive repair/remodel.

Nick Brubaker · Answer

@Bill Brandt Admittedly this is somewhat theoretical but let me try to focus my question... I live in a house for several years I move out to do a large renovation. I put $250k in and the value and basis rise $250k (no capital gains from that itself). That said some capital gains potentially from a year of the appreciation during that time. I move back in. No renting. Do I need to prorate for that period when I later sell?

Bill B. · Answer

If you never rented it out then there’s no taxes on the first $250k/$500k. But if you couldn’t live there during the renovations because it was such a big renovation you obviously couldn’t rent it out during that renovation. I guess I don’t understand why the renovation would make you want to rent it out. But short answer no. If it was never rented it out then no proration. Ps. There usually aren’t any capital gains during renovations. 99% of renovations add less value than they cost. You might be confusing added value with capital gains? If you spend $250,000 adding a pool and an adu and now the property is worth $200 or even $250k more. That’s not a capital gain. Imagine replacing the roof and painting the entire inside and outside, replacing all the flooring and the HVAC system for $60k. The house might be worth $10-20k more. You actually have a capital loss of $40-50k even though the house is “worth more”.

Nick Brubaker · Answer

Out of curiosity, if we just moved out and did a big renovation/addition and then moved back (never renting it out), would capital gains still need to be prorated when ultimately selling the house? When buying a new property and renovating initially before moving in I'm pretty sure capital gains during that time would be excluded, right? @Michael Plaks @Bill Brandt

Michael Plaks · Answer

Yes, your pro-ration will get more beneficial the longer you stay there, but it will always be partially prorated