The Section 121 Capital Gain Exclusion has a lot of questions these days. It’s a sign of the times as people are looking at real estate value increases right at the time they’re thinking of downsizing. And it all comes down to this, “Can I sell and not pay tax?”
My strong suggestion is to hire a tax professional you trust to work through your own situation. Figure out how much tax you’ll pay with the help of a tax pro and then hire them to file your tax return. In that way you can take advantage of the best strategy plus make sure your tax return is prepared properly to reflect that strategy.
If you’re going to exclude $500,000 in capital gains, that’s a savings of $119,000 (federal income tax plus NIIT) plus the state tax savings, you definitely don’t want to put it all in jeopardy by trying to do-it-yourself.
I received this question at USTaxAid:
“I cannot find the answer to this question anywhere. It’s complicated. I bought my primary residence April 1, 1999 for $268K. I started renting the guesthouse in 2000. I moved into the guesthouse for 2 years in 2012 and rented the main house. They have the same address. in 2014 I moved back into the main house with my girlfriend and rented the guesthouse. In 2017 we got married and she spent money on remodeling th property. I gave her 20% of the home for the money she spent, at that time the property was valued at $750K. in June of 2021 She and I bought a secondary home in northern Calif and started going there on July 2 2021. We rented out the primary and we never moved back. I didnt change the secondary to a primary until 2023 and we kept our drivers licenses and all utilities for the southern Cal primary at that address. that entire property has been rented ever since. Here are my questions. in 2021 when we basically moved to the secondary, we lived in our primary for 6 month and one day and we never moved our mail or drivers licenses and left it as our primary as far. as property taxes are concerned, so does that mean as far as the IRS is concerned it was still our primary until Jan 1 2022. 2nd question. if we move back into this primary can we recapture the 2 out of 5 years that ended either July 2 of 2024 or Jan 1st of 2025. if we do so I assume we have to make up all the time lost, so if July 2, 2024 was the end of the 2 out of 5 then we have to move back for 6 months and if Jan 12025 is the end of the 2 out of 5 then we have to move back for a few days. or until we close escrow. how does the apply to moving our property tax basis. if we are 6 months outside the 2 out of 5 if we move back into the old primary for 6 months and sell can we move our property tax basis. yes its complicated”
My response:
So, let’s break down this very long question into just a couple of salient points.
When you sell, you need to go back for 2 of the previous 5 years. During that time did you live in and own the property? If so, you have some capital gains exclusion. It will be possibly be limited due to it being a rental after 2009 for some years. For now, though, did you live in it for the required period of time?
I don’t see a prospective sales date in the question, so I’ll just assume you sell the Southern California property on February 1, 2025. Did you live in the property for 2 of the previous 5 years during the period 2/1/2020 – 2/1/2025? If I’m reading the question correctly, the answer is “no”. You moved to northern California on 7/1/2021, began renting out your old home and so you did not live in the southern California property for 2 full years during that period.
There are also questions about taking advantage of the reduced property tax for your primary residence and possibly using that reduction on a property you rented out. That is outside the purview of income tax prep, so I’ll just say you’ll likely need to have some help to come clean with that so you have met the requirements.
What does it take to prove you’ve actually moved to another address? For sure, one of the points will be that you moved your belongings to another address and are renting out the old one. It doesn’t matter whether you change your driver’s license or not, but it certainly would be simpler if you did. The fact that it was rented out is very clear that you are not living there anymore.
What if you wanted to take advantage of the capital gains exclusion, which is now $500,000 because you’re married? Because of the long delay from when you moved away in 2022 and now, you can’t claim temporary absence as a reason to be gone (that has to be less than one year). You will need to move back to the southern California home for at least 2 years to start the clock running again.
Because the southern California main house was your primary residence first and then became a rental, you’re not going to be required to prorate the amount of your capital gain exclusion. That is a huge benefit. If it had first been a rental, you would have to pro rate the exclusion during the time it was a rental post 2009.
However, you do need to recapture depreciation when you sell. That’s true even if you have the full capital gains exclusion on your home. If it was ever depreciated, that is now taxable at the recapture rate of ordinary income tax up to a maximum of 25% (federal tax).
Are you up-to-date on the new tax changes? Pick up your copy of the “Trump Tax Plan 2025” today!
