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Exploring IRS Section 121- Excluded Gain On Sale Of Residence- Part 2 of 4- Converting a Rental To A Primary Residence

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Exploring IRS Section 121- Excluded Gain On Sale Of Residence- Part 2 of 4- Converting a Rental To A Primary Residence

The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner to exclude up to $250,000 of gain on the sale of a primary residence (or up to $500,000 for a married couple filing jointly). In order to qualify, the homeowner(s) must own and also use the home as a primary residence for at least 2 of the past 5 years. In the case of a married couple, the requirement is satisfied as long as either spouse owns the property, though both must use it as a primary residence to qualify for the full $500,000 joint exclusion.

The use does not have to be the final 2 years, just any of the past 2-in-5 years that the property was owned. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). The fact that it was no longer the primary residence at the time of sale is permissible, as long as the 2-of-5 rule is otherwise met.

If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. In such scenarios, a pro-rata amount of the exclusion is available; for instance, if an individual had to sell the home after 18 months instead of the usual 24, the available exclusion would be 18/24ths multiplied by the $250,000 maximum exclusion, which would provide a $187,500 maximum exclusion (which will likely still be more than enough, as it’s unlikely that the gain would be more than this amount unless it was an extremely large house!).

Converting A Rental Property Into A Primary Residence

Because the exclusion is available as often as once every 2 years, some homeowners may even  try to sell and move and upgrade homes more frequently, to continue to “chain together” sequential capital gains exclusions on progressively larger homes (presuming, of course, that the real estate prices continue to rise in the first place!). In some cases taxpayers decided to go even further, taking long-standing rental property, moving into it as a primary residence for 2 years, and then trying to exclude all of the cumulative gains from the real estate (up to the $250,000/$500,000 limits), even though most of the gain had actually accrued prior to the property’s use as a primary residence! The opportunity is especially appealing in the context of rental real estate, as the potential capital gains exposure is often very large, due to the ongoing deductions for depreciation of the property’s cost basis that are taken along the way.

As with other Congress has placed limits on this technique.  Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first, created as part of the original rule under IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation  recapture will still be taxed (at a maximum rate of 25%).

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