Jane Young, CFP, EA
When you sell a home that has been rented there are restrictions on your ability to exclude all of your gains. As mentioned in last week’s article, you may be able to exclude up to $250,000 in gains if you are single and up to $500,000 if married filing jointly, assuming you have lived in your home for 2 of the past 5 years. However, after January 1, 2009, this exclusion is limited to the gain associated with the time your home was used as a primary residence. You cannot exclude any gain that may be attributable to depreciation allowed after May 6, 1997.
When you rent your home, the IRS allows you to take a depreciation deduction. This enables you to spread the cost of your property over time and temporarily shelter some of your income from taxes. Residential homes are usually depreciated over 27.5 years using the fair market value (FMV) of the property at the time you began renting the property. Only the building can be depreciated so you need to subtract the value of land from your FMV before calculating depreciation.
Depreciation can be a great way to shelter taxes, at least while you are renting your home. However, when the property is sold you cannot exclude any gain equal to the depreciation allowed or taken, even if you lived in the home for 2 of the last 5 years. The IRS refers to this as unrecaptured Section 1250 gain or depreciation recapture and this is taxed at a maximum rate of 25% instead of capital gains rates. You may be tempted to forego taking the depreciation deduction to avoid the 25% depreciation recapture. However, this is not a good idea because the IRS calculates recapture on allowable depreciation not depreciation actually taken.
If you have a loss on the sale of your home you may be able to escape recapture of depreciation. When calculating the gain or loss on the sale of your home, depreciation is deducted from your adjusted basis. If you still have a loss after deducting depreciation you will have no gain from which you need to recapture depreciation.
On the other hand, if you anticipate a substantial gain and think it may be advantageous to postpone a large tax hit, consider a 1031 exchange also known as a like-kind exchange. The IRS rules regarding 1031 exchanges are very stringent and can be quite complex. If you are considering a 1031 exchange it’s advisable to work with a tax professional that specializes in this area.
Jane Young, CFP, EA
In most situations, if you sell your personal residence that you have lived in for 2 of the last 5 years, you will qualify for an IRC Section 121 Exclusion. Section 121 excludes gains of up to $250,000 for an individual and $500,000 for a married couple filing jointly. You must own your home and use it as your primary residence. Married taxpayers may exclude up to $500,000 if either spouse owned the home for 2 of the last 5 years and both spouses lived in the home for 2 of the last 5 years. If eligible, you can use this exclusion once every two years. Any gains in excess of the exclusion will be taxed at capital gains rates. If your gain does not exceed the exclusion you don’t need to report the sale on your tax return.
If you own more than one home, you are only eligible for the exclusion on your primary residence. Additionally, you are not eligible for the section 121 exclusion if you acquired your home through a like kind exchange (1031 exchange) in the last 5 years or if you claimed an exclusion over the past 2 years. If you don’t meet the requirements because you lived in your home for less than two years and the reason for the sale is due to poor health, change of employment, death, divorce, or other unforeseen circumstances, you may be eligible for a partial exclusion. Additionally, special rules apply to qualifying members of the Uniformed Services or the Foreign Service and employees of the intelligence community and the Peace Corps. The exclusion of gains does not apply to gains attributable to depreciation claimed for rental or business use after May 6, 1997.
If you lived in your home for 2 of the last 5 years but failed to use the home as your primary residence at any time after January 1, 2009, some of your gain may be ineligible for exclusion. The time during which your home was used as a rental or vacation home is considered non-qualified use. Any gain on your home during this timeframe is not eligible for exclusion and will be taxed at capital gains rates. This does not reduce the actual amount of your exclusion and if your gain is large enough you may be able to use your full exclusion.
To calculate the gains attributable to non-qualified use, divide the number of years of non-qualified use (years home not used as primary residence after 2008) by the total number of years the home has been owned. For example if you rented your home for 4 years and owned your home for 20 years, gains attributed to non-qualified use are equal to 4/20ths or 20%. Therefore, 20% of the gain will be taxable (plus any depreciation recapture) and 80% may qualify for exclusion.
Depreciation will be addressed in Part 2 of this article.