Turning personal residence into rental property...

Tax, SDIRAs & Cost Segregation
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Turning personal residence into rental property...

Tom Wallace
Investor · East Syracuse, NY · Member since 2011 · 15 posts · 1 vote

Hi all. Want first to say how much I appreciate Bigger Pockets and the wonderful advice I have received here..

I own 3 rental properties at this point. My wife and I have lived in our personal residence for the past 15 years. I bought the house for $80000 and now it is worth about $170000. I have put probably $15000 into the house. I am the only one listed on the deed for the house.

As part of our plan to accumulate enough rental property to generate sufficient monthly cash flow to in order to retire (we also have other non real estate investments), we are planning on renting out our personal residence and moving into our next project property...This will allow us to keep the owner occupied financing that I have had in place on the house (I have checked my mortgage documents and I am in the clear to do this), intact and provide some nice cash flow that we can put to use in renovating our next project house.

I do not want to lose my one time capital gains tax exemption on my principal residence. In order to keep that, will I need to either sell that house within the next 3 years or move back into it again and live there for 2 years before I sell?

Any other advice/thoughts relating to this plan would be appreciated.

Thanks,

Tom

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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
14y

Dave T is on the money again. I'm starting to think he's trying to take my job. Consider selling now and purchasing another to exclude the current gain. You may be able to pay cash for a property or have two nice down-payments. You will also still qualify for owner-oc financing on one property.

Perfectly correct in that the exclusion can be used repeatedly in 24 month intervals and in some extreme cases sooner if certain factors apply.

-Steven the Tax Guy

Your guide to IRS laws, rules and regulations.

[email protected]224-381-2660
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  • Tino Lee
    Fremont, CA · Member since 2016 · 3 posts · 0 votes
    10y

    I purchased a property in 2003 and it was my primary residence for 10 years (2003 to 2013). It later became a rental property from 2013 to 2015 (for approx. 2.5 years) and sold it at end of 2015. This is the only property I have ever sold.

    When I fill the home sale questionaire in the tax software, it says I don't qualify for the full 250K exclusion, just partial exclusion. For the period when the property was a rental (2.5 yrs) it is being treated as unqualified usage so I am being charged capital gains tax for that time period = (2.5 yrs rental /12 yrs owned) x realized gain.

    Since the rental period occurred after primary residency and within the 5 year lookback, shouldn't that 2.5 yr rental period be considered "qualified usage"?

    My guess is that the tax software isn't taking into consideration the exceptions to nonqualfied usage.

    Am I  correct to say that I should be eligible for the full 250K exclusion?

    Here is article from the CPA journal I am getting this info from regarding exceptions to nonqualified use (discussed near the end of the article).  

    http://www.moneyradio.org/www/pdf/3092.pdf

    Exceptions IRC section 121(b)(4)(5)(c)(ii) provides the following three exceptions relating to the determination of periods of "nonqualified use": * any portion of the five-year look-back period that ends after the last date that the homeowner uses the property as a principal residence; * any period, up to an aggregate of 10 years, that the taxpayer or the taxpayer's spouse is serving on extended military duty; and * temporary absences due to change of employment, health conditions, or other unforeseen circumstances. 

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  • Tino Lee
    Fremont, CA · Member since 2016 · 3 posts · 0 votes
    10y

    Anyone?

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  • Michael Trout
    Investor · Houston, TX · Member since 2015 · 7 posts · 3 votes
    10y

    @Tino Lee You are correct that the 2.5 years of rental would not be considered nonqualified use under §121 as it occurs within the 5 year lookback period assuming you used it as your personal residence for 24 months during that period.

    There may be some other reason your tax software is marking it nonqualified though. 

    These programs like to pull dates from other sections, so it's possible that you entered a date in the section to deduct Moving Expenses that would result in you failing the 24 month residency test.

    Without seeing what you entered in your software, it is impossible to know. I'm not a tax software expert, we usually file manually as these programs are usually very basic and don't know the full extent of the tax law.

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  • Tino Lee
    Fremont, CA · Member since 2016 · 3 posts · 0 votes
    10y

    I never deducted moving expenses or used it for any other business purpose other than a rental. I'm not sure why the tax software (HR Block Premium) is not picking it  up.  It was used as primary residence first and then as a rental after that, then it was sold.  2016 may be the year I may have to pay a tax professional to do my taxes. 

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  • Brendan Reed
    Investor · Kirkland, WA · Member since 2016 · 3 posts · 0 votes
    9y

    I'm still not clear you have to pro-rate the amount of gains if you live in the house for 2 (even the last two) out of 5. Pub. 523 says that if you meet ALL three of the bullet points (below) then the rental space doesn't "still" count as a business space, and therefore doesn't affect the gain/loss calculations. So I'm confused. If you lived in a house for 1 year, rented it out for 6 years, then lived in it for 2 years, and then sold it while it was your primary home, it would count as a residence space for 2 out of the 5 years leading up to sale. If it was a rental at the time of sale, and you didn't earn an business or rental income for it in the year you sold it, then it looks like you wouldn't have to pro-rate. Am I mis-reading this, or is their another part of Pub 523 which contradicts this?

    From Pub. 523:

    Business or Rental Use of Home

    Determine whether the space used for business during the 5 years before the sale is considered to be within your home or not. If the business or rental space was physically part of the living area of your home, such as a spare room used as a bed-and-breakfast bedroom or attic space used as a home office, your business usage doesn’t affect your gain/loss calculations. Complete .

    If the business or rental space wasn’t within your living space, such as a first-floor store with residence, an apartment with its own entrance (and kitchen and bath), or a working farm with a farmhouse on the property, continue to , next.

    Determine whether the business or rental space still counts as a business space. A space formerly used for business is considered residence space if ALL of the following are true:

    • You weren’t using the space for business or rental at the time you sold the property,
    • You didn’t earn any business or rental income from the space in the year you sold your home, and
    • You used the space as residence space for 2 years out of the 5 years leading up to the sale.

    If all of these are true, your business usage DOESN’T affect your gain/loss calculations. Complete and then go to , later.

    https://www.irs.gov/publications/p523/ar02.html#en_US_2016_publink100010381

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  • Brendan Reed
    Investor · Kirkland, WA · Member since 2016 · 3 posts · 0 votes
    9y

    Keith, 

    I've read Pub 523, but can't find where it refers to something you mentioned above:

    "3) and there was no rental use of the home BEFORE Tom starting living in the home as main home (in the 5 year period)"

    In the eligibility test Pub 523 says:

    "Eligibility Step 3—Residence

    Determine whether you meet the residence requirement. If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period. It doesn't have to be a single block of time. All you need is a total of 24 months (730 days) of residence during the 5-year period."

    Also, Code Sec. 121(b)(4)(C)(ii)(I) lists the following exception to non-qualified use:

    "Nonqualified use does not include use that falls into one of the following three categories: 

    (1) Post-principal-residence use. Nonqualified use does not include any portion of the Code Sec. 121(a) 5-year period which is after the last date that the property is used as the principal residence of the taxpayer or spouse."

    But, it doesn't say the initial use as a principal residence has to been during the 5-year period, just that it had to have been used as a principal residence sometime before the 5-year period.

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