How do you calculate Capital Gains on primary-turned-rental?

Question

Someone reached out to me about selling a primary residence they've owned for 14 years, and rented out for the last 18 months.

I know just enough tax stuff to be dangerous.

The gain on the 14 years is tax free up to $500k because they're married. What about the last 18 months? I think you can't avoid taxes on that gain, but how do you account for the differences?

@Natalie Kolodij @Linda Weygant @Steven Hamilton II

Linda Weygant · Answer

Thanks for the tag, @Mindy Jensen - @Ashish Acharya nailed it. Capital Gains Exclusion up to $250,000 for Single or $500,000 MFJ. There will be depreciation recapture added back to income, taxed at the taxpayers regular tax bracket, but for 18 months of rental, it is unlikely to be very much.

Remember - the Depreciation Recapture is on the amount of depreciation allowed or ALLOWABLE, so even if they didn't take depreciation, they still get the recapture upon sale.

Lien Vuong · Answer

I believe the past 18 months is irreverent to the tax consequences as they have legally occupied the unit 2 out of the 5 years. They qualify for the owner occupied tax exemption.

Ashish Acharya · Answer

If they sell within last 3 years of moving out, there is no tax up to 500k.

Meaning they can own for 14(residence)+3 (rental)years, they should be fine.

They have to pay depreciation recapture tax, that all. 18 months rentals should be that much of depreciation recapture tax.

Kevin Gray · Answer

@Mindy Jensen

Also, they can only use the exclusion once every two years.  Because they haven't been in another primary for more than two years, I would imagine they have not used the exclusion on another primary (although it is possible under certain circumstances to have a partial exclusion under two years).  May be a good idea to confirm just in case.... better safe than sorry.

Steven Hamilton II · Answer

In some cases in this situation it's better to correct the depreciation in the year of sale to adjust gain rates or offset income in a higher bracket.

Account Closed · Answer

Hello  Mindy!  I was going to suggest a 1031 if they believe in investing on future real estate. Debbie covered that and another typical sale regarding a tax relief of selling on real estate and Owner occupation relief.

There may be other deduction and they might consider hiring an experienced tax consultant and to use that expense as a business expense that will offset their gain from selling.  They will know of any other tax credits that can be used, legally and/or what they can do or should not report regarding their tax return if even reporting the rental.  Remember, that the tax reviewer knows what you should report.  Try to use a tax consultant that also do their tax statement preparation and what you can get a way to tell or not tell the IRS.

They might be high on their sale price.  They can get that estimate from a locale Agent that will use sales comps as a base because that is usually used by lenders on real estate deals.

Michael Plaks · Answer

It could be beneficial indeed. However, doing it knowingly is not allowed.

Joshua Watts · Answer

I think if they lived in the house a total of 2 years in the last 5 years they do not own any tax up to $500k. The way I am reading your post they have lived in there home 46 months out of the last 60 months therefore they are well within the rule. With that said I am not a CPA but pretty darn sure I am correct.

Dave Foster · Answer

@Mindy Jensen, As everyone is saying they would qualify for the full exemption of 121.  Should they choose they could combine that sale and also perform a 1031 exchange and that would defer the depreciation recapture as @Debbie J. Skora said.  I'm not as concerned as she is about the holding period needing to be three full years.

The standard is still intent.  And the safe harbor of two years would negate the concern of at least one of the three years statutorially if the safe harbor were met.  Beyond that its not the length of time but the demonstration of intent that is important.

Debbie J. Skora · Answer

Yes @Joshua Watts is correct.  They qualify to exempt up to $500K of gain as a married couple filing jointly, and can rent the property for the last three years prior to a sale and still take advantage of this exemption.  If their gain is more than the $500K exemption (this is common in California and other high-appreciation areas) they can 1031 Exchange the remainder into another investment property.  If they just want to cash out, they will have capital gains tax to pay on anything over the $500K exemption.  One caveat on the 1031 exchange strategy worth mentioning:  particularly in a property that was a primary residence for a long time,  the longer you rent it out before exchanging, the better.  If they ever get audited afterward, they will be happy to have rented it the max three years before selling!

How do you calculate Capital Gains on primary-turned-rental?

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