I Had Rental Property in 2014 Stopped Renting Now I Am Renting Again in 2018 How Do I Figure Basis

Updated 12/23/2020 by Geoff Curran, Jeff Barnett, & Scott Christensen

National real estate prices have been on the ascent since 2014, and many investors who jumped into the rental industry since the Dandy Recession accept substantial gains in belongings values (S&P Dow Jones Indices, 2019). You lot might be considering selling your rental to lock in profits and enjoy the fruits of your well-timed investment, but realizing those gains could come up at a cost. You lot could owe majuscule gains revenue enhancement in addition to potential depreciation recapture on the profits from your rental auction.

One strategy for paying less tax is to move back into your rental and employ the property as a primary residence before selling. Living in your rental full-fourth dimension for at least two years prior to selling can help you take advantage of the gain exclusion of $500,000 ($250,000 if single), which tin wipe out all or most of your gain on the property. Sounds easy, correct?

Let's take a wait at some of the moving pieces for determining the taxes when you sell your rental. Factors similar depreciation recapture, qualified vs. non-qualified utilise and adapted cost basis could make you think twice before moving back into your rental to avoid taxes.

Depreciation Recapture

One of the benefits of having a rental is the ability to claim depreciation on the belongings, which allows you to offset rental income that would otherwise be taxed as ordinary income. The depreciation yous take reduces your basis in the belongings, potentially resulting in more majuscule gains when yous ultimately sell. If you sell the property for a proceeds, the amount upwards to the depreciation you took is taxed at the maximum recapture charge per unit of 25%. Any remaining gains are taxed at the lower long-term capital gains charge per unit. Moving dorsum into your rental to claim the primary residence gain exclusion does non permit yous to exclude your depreciation recapture, and then you might still owe a hefty tax bill afterward moving dorsum, depending on how much depreciation was deducted. (IRS, 2019).

When the Belongings Sells for a Loss

Keep in mind that if you sell your domicile for a loss, whether it's currently a rental or is now your primary residence, you aren't bailiwick to depreciation recapture or other gains taxes. However, due to depreciation decreasing your cost basis in the property each yr until it reaches zero, it's more common that sales of former rental homes result in gains.

Notation: You can't claim a loss for revenue enhancement purposes if the belongings sold is your master residence. Read We Sold Our Dwelling for a Loss – At present What? for more than information.

Qualified Versus Not-Qualified Utilize

You might not be allowed to claim all your primary residence upper-case letter gains exemption, fifty-fifty after accounting for depreciation recapture. This gets catchy since nosotros take to dig into recent changes with the taxation lawmaking. Since 2009, the IRS has required your ownership period to be categorized between qualifying and non-qualifying use. Qualifying apply is when the dwelling house serves as your primary residence and is eligible for the IRC Department 121 gain exclusion for the auction of master residence. Non-qualifying apply is the period where the property is rented out or serves as a secondary habitation to you lot, such every bit a vacation property.

This examination applies to buying periods starting in 2009, and information technology determines how much of your gain is eligible for the tax-free exclusion and how much is subject to upper-case letter gains taxes. Ownership periods prior to 2009 are always considered qualifying use for the purposes of this test.

You may have to prorate your upper-case letter gains exclusion based on your number of years of qualifying apply of the property. That ways if you move back in for 2 years subsequently renting for vii years, your prorated exclusion limit will equal 2/9 of the gains. If 2/ix is less than the full $500k exemption ($250k for unmarried filers), then you are limited to excluding the lower amount.

Prorating the exclusion but applies where the taxpayer used the residence for nonqualified purposes and and then converts the property to a principal residence. The opposite is non true. If the residence was used as a chief residence offset then converted to nonqualified utilize, the taxpayer may potentially authorize for a full exclusion. The IRS doesn't want people abusing the five-year dominion with rentals that they move back into just before the sale. This creates ii examples to consider.

1. If yous live in your home for two years so rent it out for two years before selling it, you qualify for the total exclusion amount due to coming together the utilise test by having lived in the home for two out of the last five years earlier the sale and meeting the ownership test.
2. If you lot rent out your belongings for two years and so move back in for two years before selling it, you must prorate your exclusion because the exception to periods of non-qualifying utilise just applies to portions of the five-year utilise test period that occur later the concluding date that the property is used as a principal residence [26 The statesC. § 121(b)(5)(C)(ii)(I)].

Annotation: If there's a gain (whether information technology's eligible for the gain exclusion or not), depreciation recapture is recognized first, prior to determining how much is tax-costless and how much is subject to capital gains taxes.

1031 Exchange of the Non-Qualifying Use Portion

If yous're facing a large taxation bill because of the non-qualifying employ portion of your holding, yous can defer paying taxes past completing a 1031 commutation into another investment holding. This permits yous to defer recognition of whatsoever taxable gain that would trigger depreciation recapture and capital letter gains taxes. More importantly, it allows you to split out tax-free and taxable portions of the belongings sale.

Note: Holding you convert to a principal residence that was function of a previous 1031 substitution must be held for a minimum of 5 years to exist eligible to receive whatever of the proceeds exclusion.

Determining Your Adapted Basis

Now that nosotros have investigated potential capital gains tax exclusions and issues like depreciation recapture that is recognized first on your rental, we'll pause down how to determine your adjusted price ground for calculating gains on the sale of your property.

Your adjusted basis is typically the original purchase toll of the home, plus improvements fabricated, minus depreciation on the belongings. An exception is if you lot converted your home into a rental when the market value of the property was beneath your adjusted basis per the formula. In that instance, your basis decreases to the fair market value of the belongings at the time information technology became a rental. This eliminates people's power to beat out the organization by renting out their dwelling house for a short period just to exist able to take the capital loss, since they can't take a loss on the sale of a main residence.

In the examples beneath, a family purchases a dwelling on January ane, 2013 for $300,000 and makes $75,000 worth of improvements through remodeling the kitchen and bathrooms. Their adjusted basis prior to converting the dwelling house into a rental is $375,000. This domicile is their principal residence for two years.

Scenario ane

The couple then rents out the home starting on January 1, 2022 for iv years prior to selling it for $525,000. During the four-year rental period, they have approximately $40,000 of depreciation. When they sell the property on January 1, 2019, its adjusted ground is $335,000 ($375,000 – $40,000 depreciation taken). The gain on the sale is $190,000.

Even though 33% of their buying menstruation was for qualifying utilise, they neglect the gain exclusion test by 1 year because the home was not their main residence for 2 of the concluding five years. Therefore, the entire gain is subject area to tax.

The start $xl,000 of the proceeds is subject field to depreciation recapture at up to a 25% revenue enhancement rate. The remaining $150,000 of gain is subject field to long-term capital gains taxes (plus the 3.8% net investment income surtax if their AGI exceeds the applicable threshold).

Note: The couple could instead complete a 1031 exchange into another investment property to defer recognition of any taxable gains.

Scenario 2

This is the same as Scenario 1, except afterwards the iv-year rental period, the couple moves back in full-time for two years prior to selling the home on Jan 1, 2021. We'll use the aforementioned dollar amounts as above.

Since the couple meets the requirements to utilize the revenue enhancement-free proceeds exclusion, we demand to break downwardly the gain based on qualifying employ and non-qualifying utilise:

• Qualifying utilize– The abode was their primary residence for iv years out of the eight-year holding menstruum, so 50% of the gain is eligible for the tax-complimentary exclusion.
• Non-qualifying apply– The home was not their primary residence for four years out of the viii-yr holding period, and so fifty% of the proceeds is subject area to capital gains taxes.

Notation: Depreciation is recaptured showtime and then the remaining gain is dissever between qualifying and non-qualifying use.

Of the $190,000 gain, the commencement $forty,000 is field of study to depreciation recapture upwards to 25%. Since the gain is greater than the depreciation recapture amount, the remaining $150,000 ($190,000 – $twoscore,000) must be allocated between qualifying and non-qualifying use. The $75,000 ($150,000 × l%) related to the qualifying use office of the gain is tax-free as part of the Department 121 proceeds exclusion. While the remaining $75,000 related to non-qualifying apply is subject to capital gains taxes.

Scenario 3

This is similar to Scenarios i and ii, except the couple buys the home on Jan 1, 2003 and then rents out the domicile for 10 years starting on January 1, 2005. They move back in total-time on January 1, 2015. They sell the property two years subsequently on January 1, 2017, with depreciation of $seventy,000 over the rental menses.

As a result, the holding's adjusted basis is $305,000 ($375,000– $70,000 depreciation taken). The gain on the auction is $220,000 ($525,000 – $305,000).

Since the couple meets the requirements to use the tax-costless gain exclusion, nosotros demand to break down the gain based on qualifying use and not-qualifying employ:

• Qualifying utilize– The home was their chief residence for 4 years out of the fourteen-year holding period. Also, four years of the 10-year rental menstruum are considered qualifying use considering they occurred prior to 2009 where all ownership is considered qualifying use for the purpose of this test. Therefore, 8 years, or 57% of the proceeds is attributable to qualifying utilize and is eligible for the tax-free gain exclusion.
• Non-qualifying employ– Six years of the rental catamenia is considered not-qualifying use, so 43% of the gain is taxable.

Of the $220,000 gain, the first $70,000 is discipline to depreciation recapture at up to 25%. Of the remaining $150,000 gain (appreciation higher up the original basis), $85,500 ($150,000 × 57%) is considered qualifying use and is eligible for the home sale exclusion and is taxation-costless. 64,500 ($150,000 × 43%) is considered non-qualifying apply and is subject to capital gains taxes.

Scenario 4

This is similar to Scenario 2, except the home sells for $395,000 instead of $525,000. With an adapted footing of $355,000, this means the holding sold for a $40,000 gain.

The buying period was l% qualifying and 50% non-qualifying and the couple is eligible for the proceeds exclusion for the qualifying portion, but depreciation recapture is recognized offset. Since the gain is $40,000 and the depreciation recapture of $40,000 x up to 25% is paid first, there is no gain left over that'due south tax-free or taxable at uppercase gains rates. It's important to realize that whether information technology'south qualifying or non-qualifying, depreciation recapture revenue enhancement is paid first when there's a proceeds.

Recordkeeping

It'south important to go on good records of all improvements you make to the home. Every dollar can help reduce taxes you may owe on the proceeds one mean solar day. For more than information, read Why Information technology's Important to Keep Runway of Improvements to Your House.

Moving back into your rental to qualify for the principal residence capital gains exclusion might non help reduce your tax bill much if you accept substantially depreciated your holding or owned the existent estate for by and large not-qualifying use. Other options similar deferring taxes with a 1031 commutation could also be more helpful for managing your taxation payment than selling your rental outright. Agreement the best approach for your personal situation might not be simple, just we beloved digging into these questions here at Merriman. Contact the Merriman team if you would like help strategizing the auction of your rental and managing your wealth with an eye for the big picture.

References

Exclusion of gain from sale of principal residence, 26 United states of americaC. § 121 (2017). Retrieved from https://www.govinfo.gov/content/pkg/USCODE-2017-title26/html/USCODE-2017-title26-subtitleA-chap1-subchapB-partIII-sec121.htm

Internal Acquirement Service. (2019, March viii). Belongings (Basis, Sale of Home, etc.). Retrieved from https://world wide web.irs.gov/faqs/capital-gains-losses-and-sale-of-abode/property-basis-sale-of-home-etc/property-basis-sale-of-habitation-etc-five

S&P Dow Jones Indices. (2019, August 27). Phoenix Replaces Las Vegas as Top City in Almanac Gains According to S&P CoreLogic Example-Shiller Index [PDF file]. Retrieved from https://my.spindices.com/documents/indexnews/announcements/20190827-981359/981359_cshomeprice-release-0827.pdf

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Source: https://www.merriman.com/wealth-preservation/planning-on-moving-back-into-your-rental-in-the-future-read-this-first/

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