Converting a Rental to a Home

A $250,000 ($500,000 for joint filers) exclusion is available to offset the gain from the sale of a taxpayer’s principal residence. This exclusion can be used repeatedly, provided the eligibility requirements are met, but generally not more than once every two years.

This often tempts owners of rental properties to sell their current home—their principal residence—to utilize the exclusion, and then occupy one of their rental properties until the requirements are met to be eligible for the exclusion again.  If the taxpayer owned multiple rentals, the same process could be applied to each property, allowing the individual to benefit from the exclusion numerous times.

When the rental is not a place in which the taxpayer would want to live during the qualification period, the rental can be swapped through a tax-deferred exchange for a more suitable one, which the property owner must rent out for a reasonable period of time before occupying it to meet the exclusion qualifications. These types of transactions became so popular that Congress passed two laws to make it more difficult to achieve this tax-saving strategy.

Generally, to qualify for the gain exclusion, a taxpayer must own and use the home as a primary residence for two of the five years prior to the sale. However, if the home was acquired by means of a tax-deferred exchange, Congress increased the ownership requirement from two years to five years, thereby requiring the taxpayer to wait five years before being able to qualify for the home sale gain exclusion for the exchanged property. 

Beginning in 2009, Congress added yet another roadblock to this strategy by making the gain attributable to nonqualified periods nonexcludable. “Nonqualified use” is when the home isn’t used as the taxpayer’s principal residence. Luckily, this restriction was not implemented right away. Instead, it was phased in by only counting periods of nonqualified use beginning in 2009, and grandfathered in periods before 2009 as qualified use. However, over time, this new law will diminish the benefits from this strategy.

Keep in mind that even when a home qualifies for the home gain exclusion, the gain attributable to the depreciation allowable after May 5, 1997 on the home, and prior rental in case of an exchange, is not excludable and will be taxable.

Although these laws have complicated the benefits of converting a rental property to a primary residence prior to sale, with careful planning the strategy is still a viable one and can provide shelter from rental gains. Please call this office for more information.

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