Should I owe Capital Gains Taxes if I lived in the house 3 years then leased 2 years?

[Sergio Rodriguez]

Hello Friends, 

I purchased a house in 2017 and lived there for 4 years as my homestead's primary residence. Following that we moved out and turned it into a short-term vacation rental around April 2021 and the last year before we sold the house in December 2022, we leased it out as a long-term rental for 1-year. My tax specialist is telling me I owe about $16k in capital gains tax because I had converted the house for commercial use. However, the house was still under our name and not converted into our LLC.

Overall, I expected to pay no capital gains tax seeing as how we lived in the house 4 years out of the +5 years I owned it. I reviewed the IRS publication 523 for additional guidance but it's not clear to me (non-tax fellow) if I am exempted from capital gains. Any guidance will help!

Timeline of events: 

2017 March - Purchased house as the primary residence

2021 May - House used as Airbnb

2022 November - 1-year Lease Expired 

2022 Dec - Sold House

[Matt Devincenzo]

Unless I missed something then ypu qualify for the 121 exclusion. There would be a pro-ration if you moved back in after moving but it doesn't sound like that's the case....you will owe recapture on depreciation taken, but not capital gains. 

[Sean O'Keefe]

@Matt Devincenzo I agree - Section 121 Exclusion applies in this case. 

@Sergio Rodriguez your CPA mentioned is likely the Depreciation Recapture but we'd need more details to be certain. 

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*This post does not create a CPA-client relationship. The information contained in this post is not to be relied upon. Readers are advised to seek professional advice.

[Account Closed]

Quote from @Sergio Rodriguez:

Hello Friends, 

I purchased a house in 2017 and lived there for 4 years as my homestead's primary residence. Following that we moved out and turned it into a short-term vacation rental around April 2021 and the last year before we sold the house in December 2022, we leased it out as a long-term rental for 1-year. My tax specialist is telling me I owe about $16k in capital gains tax because I had converted the house for commercial use. However, the house was still under our name and not converted into our LLC.

Overall, I expected to pay no capital gains tax seeing as how we lived in the house 4 years out of the +5 years I owned it. I reviewed the IRS publication 523 for additional guidance but it's not clear to me (non-tax fellow) if I am exempted from capital gains. Any guidance will help!

Timeline of events: 

2017 March - Purchased house as the primary residence

2021 May - House used as Airbnb

2022 November - 1-year Lease Expired 

2022 Dec - Sold House

Hey Sergio, 

You should qualify for the 121 exclusion and likely not owe any taxes. It maybe the case that your accountant either doesn't know this rule or is factoring in something else 

[Joshua Thompson]

They may be thinking about the qualified vs nonqualified use of the home and either taxing the entire gain or a portion of it. Though in general, their thinking isn't wrong, they may want to visit section 121 nonqualified use details. I agree with the above comments that depreciation recapture does need to be included. 

I can't say the tax balance is completely incorrect because A LOT of items can affect this number. I would respectfully mention your opinion and findings to them and ask for their thoughts.

Keep in mind if you are just now filing the 2022 tax return then penalties and interest could be increasing this number.

[Sergio Rodriguez]

I received an update from my accountant and it seems the timeline of events did provided some clarification and reduced my taxes by $6k from the original $16k. 

I was advised that the depreciation taken during the years it was rented is not excluded from the exemption. 
True? 

[Sean O'Keefe]

Quote from @Sergio Rodriguez:

I received an update from my accountant and it seems the timeline of events did provided some clarification and reduced my taxes by $6k from the original $16k. 

I was advised that the depreciation taken during the years it was rented is not excluded from the exemption. 
True? 

Tax strategies to defer Depreciation Recapture (e.g. depreciation taken during the years) include 1031 Exchange. The Section 121 Exclusion doesn't provide an exemption or deferral on Depreciation Recapture. 

[Joshua Thompson]

Quote from @Sean O'Keefe:

Quote from @Sergio Rodriguez:

I received an update from my accountant and it seems the timeline of events did provided some clarification and reduced my taxes by $6k from the original $16k. 

I was advised that the depreciation taken during the years it was rented is not excluded from the exemption. 
True? 

Tax strategies to defer Depreciation Recapture (e.g. depreciation taken during the years) include 1031 Exchange. The Section 121 Exclusion doesn't provide an exemption or deferral on Depreciation Recapture. 

 Sean is correct here and put it perfectly!

[Michael Plaks]

@Sergio Rodriguez

As my colleagues said, depreciation recapture tax does apply. Capital gains tax does not.

I'm not sure what $16k/$10k represent, but my guess is that it is the balance you owe the IRS. If my guess is correct, this number is totally meaningless. It only tells how much you underpaid and does not tell how much impact the sale of your property made.

If you want to be more comfortable with the result, pay an experienced real estate accountant to review the work of your tax guy before it is submitted to the IRS. Mistakes in reporting sales of properties are common.