Tax Issues When Converting a Rental to Your Personal Residence

Article Highlights:

• Sale of a Rental Property Converted to a Personal Residence
• Exclusion of Gain on Sale of Personal Residence – The Ownership and Use Tests
• Partial Exclusion of Gain
• The Impact of a Rental Period After 2008
• Depreciation Recapture
• Reporting the Sale

Deductions When a Rental Property Is Converted to a Personal Residence

Converting a rental property to a personal residence raises unique tax implications.  If you own a home that you currently rent out and are thinking of converting the property to use as your personal residence, here are issues you should be considering.

On conversion, you can no longer deduct the same expenses – such as costs of utilities, home insurance and repairs – that were deductible when the property was a rental.  However, the deductions for mortgage interest expense and property taxes will be available and can be useful if your itemized deductions exceed the standard deduction. Even so, these home-related deductions may be limited, depending on the mortgage (loan) amount (for the interest deduction) and whether the overall state and local taxes you paid during the year exceeded $10,000 (for the property tax deduction).  Some credits may also be available, such as those for installing a solar system or making energy-efficient home improvements.

The more complex impact of the conversion occurs when the property is sold.  As a personal residence, some or all of the gain on the sale of the property, if any, can qualify for exclusion from income under certain conditions.

Loss on Sale of a Personal Residence

You cannot deduct a loss incurred on the sale of your personal residence as nonbusiness losses are not deductible.

Exclusion of Gain on Sale of Personal Residence – The Ownership and Use Tests

When certain conditions are met, a single taxpayer may be able to exclude from income up to $250,000 of the gain on the sale of a personal residence, while up to $500,000 of gain can be excluded on a joint return. The exclusion is allowed each time a taxpayer meets the eligibility requirements, but generally no more frequently than once every two years.

The general qualification for exclusion of gain on the sale of a personal residence is subject to two tests: the ownership and use tests.

The ownership test requires that you have owned the home for at least two of the five years leading up to the home’s sale date.

The use test requires that you must have lived in the home as your main residence for at least two years during the 5-year period ending on the date of the sale.  This period does not have to coincide with the two-year period that meets the ownership test.  For example, you may have rented and lived in the property for two years then bought the property from the landlord.  Then you may have rented the property out for the next two years before selling it.  You would have satisfied the use test in the two years while renting the property from the previous owner.  And you would have satisfied the ownership test in the two years before the sale while the property was rented out.  Thus, the sale qualifies under the ownership and use tests.

If you are married, to be eligible for the $500,000 exclusion, either you or your spouse may have been the owner during the testing period, but both of you must meet the use test.

If you originally acquired the home via a tax-deferred exchange, then you (or your spouse, if married) must own the home for a minimum of five years before the home sale exclusion can be used, provided you (and your spouse, if married) also meet the 2-year use test.

Partial Exclusion of Gain

If the ownership and use tests are not met, the sale of a personal residence may still qualify for a partial exclusion of gain if the reason for the sale was work-related, health-related, or triggered by an unforeseen event.  IRS Publication 523 provides details as to how each of these situations is determined.

A work-related move involves:

1. A new job location that is at least 50 miles further from your home than your previous job location; or
   
   
2. If no previous job location, a new job that is at least 50 miles from your home; or
   
   
3. Either of the above is true for your spouse, a co-owner of the home, or anyone else for whom the home was a residence.

A health-related move involves:

1. A move “to obtain, provide, or facilitate diagnosis, cure, mitigation, or treatment of disease, illness, or injury for yourself or a family member.”
   
   
2. A move “to obtain or provide medical or personal care for a family member suffering from a disease, illness, or injury. A family member includes your:
   
   a)   Parent, grandparent, stepmother, stepfather;
   b)   Child (including adopted child, eligible foster child, and stepchild) or grandchild;
   c)   Brother, sister, stepbrother, stepsister, half-brother, half-sister;
   d)   Mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law; or
   e)   Uncle, aunt, nephew, or niece.”
   
   
3. You moved pursuant to a doctor’s recommendation because you were experiencing a health problem.
   
   
4. “The above is true of your spouse, a co-owner of the home, or anyone else for whom the home was his or her residence.”

An unforeseeable event includes any of the following that occurred while you owned and lived in the home:

1. The home was destroyed or condemned.
   
   
2. A natural or man-made disaster or act of terrorism caused a casualty loss to your home whether the loss is deductible on your tax return or not.
   
   
3. Anyone for whom the home was a residence:
   
   a.   Died.
   b.   Divorced, was legally separated, or was issued a decree to pay maintenance to the other spouse.
   c.   Gave birth to two or more children from the same pregnancy.
   d.   Became eligible for unemployment compensation.
   
   
4. Became unable to pay basic living expenses due to a change in employment status (basic living expenses include food, clothing, housing, medication, transportation, taxes, court-ordered payments, and expenses reasonably necessary to make an income).
   
   
5. IRS published guidance determines an event to be unforeseen.

Even if a situation doesn’t fit these specific classifications, it may still qualify for a partial exclusion of gain if it occurs while you own your home, you sell the home shortly afterward, you couldn’t have reasonably anticipated the event when you bought the home, you have had financial difficulty maintaining the home, and/or the home became significantly less suitable for you and your family for a specific reason.

If a sale qualifies, the partial exclusion is calculated by taking the shortest of:

1. The number of days or months of residence in the home over the past 5 years;
   
   
2. The number of days or months of ownership of the home immediately prior to the sale; or
   
   
3. .   The time between the sale of the home and the last time that you sold a home for which you claimed a personal residence gain exclusion.

The smallest of these periods is divided by 730 (if calculated in days) or 24 (if calculated in months).  Multiply the result by $250,000.  If the property is sold and you are married and filing jointly, do the same calculation for your spouse and add the two results together to determine the maximum amount of gain that you can exclude from income.

The Impact of a Rental Period After 2008

A special rule enacted in 2008 requires the proration of gain on the sale of a personal residence that was initially used other than as a personal residence.  The percentage of time that the property was used for a nonqualifying use (such as a rental) must be considered to determine the maximum gain exclusion for the property.  For example, if a property was purchased after 2008 and rented for 2 years before it was converted to a personal residence, the gain exclusion amount must take those two years of nonqualifying use into account to determine the maximum gain exclusion available.  If the property was sold after it was owned for 5 years, for example, then the maximum exclusion amount is 60% of the $250,000/$500,000 exclusion figures since the property was a personal residence for three of the five years it was owned.

Depreciation Recapture

The sale of a residence that has been converted from rental to personal use triggers the recapture of depreciation claimed during the time the property was used as a rental.  This recapture is reported as ordinary income on the tax return for the year of the sale and is taxed at the taxpayer’s highest tax rate up to a 25% cap.

Reporting the Sale

The sale or exchange of your primary residence is reported on Form 8949, Sale and Other Dispositions of Capital Assets, if:

• You have a gain and it is not fully excludable from income,
  
  
• You have a gain and choose not to exclude it, or
  
  
• You received a Form 1099-S, Proceeds from Real Estate Transactions. This form is prepared and issued to you, with a copy to the IRS, by the settlement agent, such as an escrow company or attorney.

Even if you didn’t receive a Form 1099-S, and the gain is fully excludable, it may be prudent to report the sale on Form 8949 anyway so that there’s an income tax record of the transaction.

If you are contemplating converting a rental to a personal residence, we can help you determine tax ramifications in advance.  Please call for assistance.

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