I received this question at USTaxAid.com. Following is a summary of the details and then we get to the question. Be careful, it’s tricky.
Prop A was bought in 1987 as a personal residence. Rented it from 1994 – 2013.
Sold Prop A and did a like kind exchange to Prop B in 2013.
Will sell Prop B in 2021 and like kind exchange to Prop C.
Now comes the question. Can they rent out the property for 2 years and then live there for a few years to get the 2 out of 5-year capital gains exclusion?
It’s complicated. That’s the short answer.
Now, here’s the long answer. Let’s look at the different parts of this plan, in light of the current law as of January 2021.
A like kind exchange (aka Starker Exchange aka Section 1031) allows you to sell a rental property and defer the gain, provided you buy the right property in the right way.
I’ll assume that the community member with the question knew how to do a legal like kind exchange since he had done that a few times before.
The other real estate tax law that comes into play allows you to take a capital gains primary residence exclusion of up to $250,000 for single taxpayer ($500K for a married, filing jointly), provided you meet the requirements of living in the home 2 of the previous 5 years.
For years, that was the only requirement. Then, effective 1/1/2009, Congress limited the exclusion if a property started out as a rental and then was changed to a primary residence.
Under this change the capital gain exclusion is only available for periods during which the property was a primary residence.
So, as an example, let’s say that Property C was a rental for 2 years and then lived in as a primary residence for 4 years. Prior to 2009, there would have been a full capital gains exclusion allowed.
Now, however, you have pro-rate the gain based on the qualifying (primary residence) and non-qualifying (rental) use. In that case, there would be 2/6 as a rental (2 out of 6 years total) and 4/6 as a primary residence (4 out of 6 years total).
Let’s say that there is $300,000 in total of capital gains. 1/3 (2 out of 6) would be taxable. So, $100,000 is taxable. 2/3 (4 out of 6) is available for the capital gain exclusion. That would be $200,000 in our example.
The taxpayer also would have to recapture depreciation, up to the amount of gain. Since this particular property (Prop C) has rolled over basis and depreciation from both Property A and Property B, there could be a lot of depreciation. But in this example, you can’t be forced to recapture more than $100,000.
There is also an exception to that. If it turns out that the taxpayer has a home office and depreciates that part of the house while they are living in it as a primary residence, then that will also need to be recaptured. That is over and above the depreciation recapture from the rental prior to living in the home.
There was also a change to tax law that now allows like kind exchanges to be used for primary residences. As long as you live in the new property for 5 years. If you rent it first, you have to pro-rate gain. If it is just sitting vacant for 2 years, that doesn’t apply. If it becomes a rental property, then you need to pro-rate gain.
If you google the 2 out of 5 primary residence rules, you’ll likely find people still talking about turning a rental into your primary residence and then all is well.
It’s not. It changed 12 years ago.
And this is why it’s so important to make sure the tax information you get is #1 from someone who knows what they’re talking about and #2 is current.
Every Monday at 9 am Pacific, I do a Livestream at Facebook Diane Kennedy’s US Tax Group.