Converting a rental property into a primary residence is a significant financial move with potential tax implications that necessitate careful planning. By leveraging tools like Section 121 of the IRS code and 1031 exchanges, homeowners can navigate the complexities of this process. However, understanding the intricacies of these laws is crucial. Here’s how to convert a rental property into a primary residence the right way.
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Converting a rental property into a primary residence is possible, but doing so can have unwanted tax implications if you go in blind. Fortunately, tax exemptions are available through Section 121 of the IRS code and 1031 exchanges. Depending on the situation, you can apply one or both of these tools to minimize your tax burden when converting a rental property. Here are how these two tools work:
Section 121 of the Internal Revenue Code exempts up to $250,000 (or $500,000 for a married couple filing jointly) of capital gains from the sale of a primary residence if you’ve owned and lived in the property for at least two of the past five years.
To qualify, you need to have owned the property and lived in it as your primary residence for at least two years out of the five years leading up to the sale. While a 1031 exchange affects this exclusion, they can work together to create a tax advantage, as you’ll see in later sections.
A 1031 exchange, also known as a like-kind exchange, allows you to delay capital gains taxes when selling an investment property by purchasing a similar property with the proceeds. You can defer these taxes in perpetuity every time you sell an investment property by acquiring other investment properties of like kind.
Once you’ve sold a rental property, you have 45 days to identify potential replacement properties for a 1031 exchange. You can identify a property with the same price tag or multiple properties with a combined value of 200% or less of the value of the property you sold. You have 180 days from the sale of the original property to purchase the replacement property.
Section 121 exclusions and 1031 exchanges are complex financial moves with various rules and boundaries homeowners must follow to avoid penalties. Here’s what to remember:
The IRS scrutinizes intent when you convert a rental property to a primary residence. As a result, it’s vital to document your initial intent to rent out a property when you first acquired it. Specifically, you’ll provide rental agreements with tenants, public listings advertising the rental unit and financial records showing rental income.
Renting out a 1031 exchange property complicates your ability to claim the Section 121 exclusion later because you must fulfill the requirements for both. Doing so is still possible, but you must complete a 24-month holding period where you rent out the property instead of living in it.
Specifically, every 12 months, you can live in the property for 14 days or 10% of the days you rented out the property, whichever is less. You must complete this 12-month process twice so your ownership lasts for 24 months without using the property as your primary residence.
After this period expires, you can move into the property and make it your home. Then, to qualify for a Section 121 exclusion, you must treat the property as your primary residence for at least two years out of the five years that precede selling the home.
The Section 121 exclusion is available to individuals or married couples filing jointly. This tax break is unavailable if a company, group, or business partnership owns the property.
Owning a rental property means you can take a specific tax deduction for asset depreciation every year. However, you’ll owe the deducted amount if you sell the property after turning it into your primary residence. This aspect can erode the Section 121 exclusion you receive when selling.
Tax laws dictate a five-year holding period for 1031 exchanges that become primary residences. Specifically, you must own the property for a total of five years or more to receive a Section 121 exclusion.
For example, say you purchase a property and rent it out for two years. You then decide to live in the property as your primary residence for two years, resulting in a four-year holding period. You won’t be eligible for a Section 121 exclusion if you sell the property at that time. Instead, you must wait at least one more year so that you’ve held the property for five years.
An update to the tax code applies to properties acquired after 2009. Specifically, the 121 exclusion shrinks according to how many years you rented out the property versus treating it as your primary residence.
For example, say you buy a rental property in 2017 and rent it out for three years. Then, you convert the property to your primary residence. You live in the property for five years, resulting in a seven-year holding period in total (two years renting out plus five years as your primary residence). The two rental years create a long-term capital gains allocation in the following way: you’ll owe 2/7ths of the capital gains taxes you incur and can exclude 5/7ths from taxation.
Here’s an example to draw together the points about 1031 exchanges and Section 121 exclusions, along with their implications and requirements:
Say that you have a small piece of commercial real estate valued at $300,000 that isn’t performing well. You bought this commercial real estate for $200,000, so you can sell it for a $100,000 profit.
You sell the commercial real estate and buy a single-family home for $300,000. Because you acquired a similarly valued real estate investment, you use a 1031 exchange to delay paying capital gains taxes on the $100,000 from selling the commercial real estate and $30,000 of depreciation recapture taxes.
You rent out the property for four years, and then upon retiring you decide to spend your golden years in the countryside. So, you convert the rental property into your primary residence for the next five years until you decide to sell your home and move to a warmer climate.
Remember, your 1031 exchange from the past means you’re liable for the capital gains taxes on the $100,000 profit you made when you sold your initial investment property to buy the one in the countryside. Fortunately, your nine-year holding period qualifies you for a Section 121 exemption, mitigating your tax burden.
The property has appreciated to a $650,000 value. You’ve put $50,000 of work into the home, so your cost basis is $350,000. Your capital gain upon selling the property is $300,000. In addition, the deferred $100,000 of capital gains from the sale of your initial investment property and the $30,000 of depreciation recapture taxes are in play.
Therefore, you face $400,000 of long-term capital gains. Fortunately, you are eligible for a Section 121 exclusion. Specifically, you lived in the home for five out of the nine years you owned it. So, you can exclude 5/9ths, or 55%, of your capital gains. $400,000 x 0.55 = $220,000. This leaves you with $180,000 that the government will tax.
Your income places you in the 15% bracket for capital gains taxes. So, $180,000 x 0.15 = $27,000 of capital gains taxes on the sale of the home. Plus, you owe $30,000 of depreciation recapture taxes, creating a total tax bill of $57,000 when you sell.
Here are five common tips to help you successfully convert a rental property to a primary residence:
If you decide you no longer want to go through with the 1031 exchange, you can reverse the transaction. However, you may have to hold the property for a specific period before reversing it, and you will be liable for capital gains taxes on the original property’s sale. Additionally, any depreciation recapture that you deferred would become immediately due.
Therefore, it’s recommended to consult with a qualified tax advisor or attorney if you’re considering reversing a 1031 exchange. They can provide specific guidance based on your situation and help you understand the potential tax consequences.
Converting a rental property into a primary residence involves careful planning and consideration of various tax implications. Section 121 of the IRS code and 1031 exchanges offer valuable tools to minimize tax burdens in this process. However, homeowners must navigate rules and boundaries, such as proof of intent to rent, rental period requirements and the five-year holding period. Taking these considerations into account can lead to a successful transition from rental property to primary residence while optimizing tax benefits.
Photo credit: ©iStock/Inside Creative House, ©iStock/fizkes, ©iStock/Natee Meepian
Ashley KilroyAshley Kilroy is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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