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Tax Consequences of Converting a Rental Property into a Primary Residence

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Do you own a residential rental property that you plan to convert into your primary residence? Are you wondering if by doing so, you could still qualify for the capital gains exclusion on sales of a primary residence, when you do eventually sell? This article will examine these questions, and will explain some of the basic tax rules involved in turning a rental property into a primary residence.

The Capital Gains Exclusion for Sale of a Primary Residence- General Rules

In general, under Internal Revenue Code (IRC) section 121, taxpayers who reside in a primary residence, and who have both owned and lived (or used as a primary residence) in a home for at least two years within a five year period may qualify for the full capital gains exclusion of $500,000 on a joint filed tax return ($250,000 per spouse). However, taxpayers must not have already claimed this exemption within the past two years. Typically, each spouse of a married couple must meet both requirements in order to get the full exclusion. Certain exceptions may be available if the requirements are not met, depending upon the taxpayer’s circumstances. You will need to consult a tax attorney on this issue.

In converting a residential rental property into a primary residence, it should be noted that any depreciation taken while the property was a rental will not qualify for the capital gains exclusion, and will instead be subject to depreciation recapture. Depreciation deducted before May 6, 1997 will reduce the adjusted basis of a rental property, whereas depreciation deducted after that date will be taxed as a capital gain.

Non-qualified use of a Rental Property

In 2008, Congress amended IRC section 121, with the Housing and Economic Recovery Act, to add a limitation of the capital gains exclusion due to “nonqualified” use of a converted rental-to-primary residence. “Qualified” use is defined as any use of the property as a primary residence. “Non-qualified” use is defined as any use of the property other than as a primary residence, such as as a second home, a vacation property, a rental or investment property, or use of the property in a trade or business.

In general, the effect of the change is to limit the amount of capital gains exclusion to an allocation formula dependent upon non-qualified and qualified use of the property. For example, if the property is held for ten years and then sold, and for six of those years it was used as non-qualifying property, then 6/10 of the capital gain, would not be excluded. However, subject to certain exceptions, non-qualified use prior to January 1, 2009 will be ignored for purposes of the section

Contact Sherayzen Law Office For Tax Planning With Respect to Rental-Primary Residence Tax Planning

Taking advantage of the IRC section 121 capital gains exclusion may require detailed knowledge of the relevant tax rules and careful tax planning. Obviously, this article only provides some general background information for education purposes and should NOT be relied upon as a legal advice. Rather, you should contact Sherayzen Law Office to set up a consultation to discuss your particular fact situation. Our experienced tax firm will help you determine whether you may be able to take advantage of the IRC section 121 and how to do it.

Obtaining Private Letter Rulings

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At certain times, tax planning may involve taking a position on a tax return that is uncertain, or even controversial. If the position involves a potentially large liability, taxpayers may be left with the undesirable choices of either taking a risk in reporting the position or deciding not to and paying a much larger tax.

Thankfully, in some instances, the IRS allows for a way to receive clarification on a specific tax position for individual taxpayers, called Private Letter Rulings. The basic mechanism of obtaining a Private Letter Ruling is the essence of this essay.

Private Letter Rulings are issued by the National Office of the IRS upon request by individual taxpayers. Basically, Private Letter Rulings state how a specified tax position will be treated by the IRS if it is taken on a tax return. Hence, this process is one of the best ways to ensure proper, safe tax planning on otherwise potentially risky positions. The IRS will only issue letter rulings based upon actual transactions (even if they have not been completed yet); mere hypothetical scenarios will not qualify. While the IRS is not legally bound by letter rulings, in general, it has honored the determinations made to specific taxpayers.

A Private Letter Ruling that is issued to an individual taxpayer must be attached to the tax return filed for the year that the position in question is reported. In certain circumstances, the IRS may issue subsequent determinations to other taxpayers, based upon almost the same set of facts, that seem to contradict the earlier letter ruling. Generally, in such cases, the new ruling will not be applied retroactively to the original taxpayer who requested a letter ruling.

Furthermore, the IRS is required to make Private Letter Rulings available for the general public, with identifying individual details removed. In most cases, a Private Letter Ruling only applies to the individual taxpayer who request it. For the purposes of avoiding accuracy-related penalties, however, Private Letter Rulings issued after 1984 may be used as substantial authority by other non-requesting taxpayers.

Because a letter ruling represents the current IRS view of a tax issue, letter rulings may be superseded by new case law. Keep in mind, however, that there are limitations with respect to the IRS revocation or modification of a letter ruling sent to an individual taxpayer.

Of course, as most things in life, the benefits of a Private Letter Ruling come with certain costs. There is a fairly steep fee charged by the IRS for making a request. In addition, the legal fees involved in obtaining a Private Letter Ruling are often comparable to an administrative appeal or an arbitration case (depending on the complexity of your case). Also, there are certain prescribed areas of the law that the IRS will not rule on for Private Letter Purposes. The same applies to requests that involve only issues of fact. In fact, the complexity of obtaining the Private Ruling is such that your best course of action is to retain a tax attorney if you seek to minimize your potential tax liability and audit risk by requesting a letter ruling.

Contact Sherayzen Law Office For Help In Obtaining a Private Letter Ruling

Obtaining a Private Letter Ruling usually involves complex issues, and this articles only provides a very general background information that should not be relied upon in making the determination of your specific situation. Rather, if you would like to consider obtaining a Private Letter Ruling from the IRS, you should contact Sherayzen Law Office for legal help. Our experienced tax firm will help you determine whether your case qualifies for a Private Letter Ruling, whether this is the best course of action available, and provide rigorous, ethical and affordable IRS representation.

IRS Announces 2012 Standard Mileage Rates

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On December 9, 2011, the Internal Revenue Service issued the 2012 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

Beginning on January 1, 2012, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

  • 55.5 cents per mile for business miles driven;
  • 23 cents per mile driven for medical or moving purposes;
  • 14 cents per mile driven in service of charitable organizations.

The rate for business miles driven is unchanged from the mid-year adjustment that became effective on July 1, 2011. The medical and moving rate has been reduced by 0.5 cents per mile.

The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs as determined by the same study.

Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates.

A taxpayer may not use the business standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Section 179 deduction for that vehicle. In addition, the business standard mileage rate cannot be used for more than four vehicles used simultaneously.

These and other requirements for a taxpayer to use a standard mileage rate to calculate the amount of a deductible business, moving, medical or charitable expense are in Rev. Proc. 2010-51.

Notice 2012-01 contains the standard mileage rates, the amount a taxpayer must use in calculating reductions to basis for depreciation taken under the business standard mileage rate, and the maximum standard automobile cost that a taxpayer may use in computing the allowance under a fixed and variable rate plan.

Alternative Minimum Tax Foreign Tax Credit

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US persons are taxed on their worldwide income, but are allowed a foreign tax credit (FTC) for foreign taxes paid. In most cases, the FTC gives taxpayers a dollar-for-dollar credit against their US tax liability.

However, the FTC may be limited for Alternative Minimum Tax (AMT) purposes in order to ensure that a taxpayer’s US liability is only reduced on foreign-source income. This article will briefly examine some of the basic elements of the Alternative Minimum Tax Foreign Tax Credit (AMTFTC).

Alternative Minimum Tax Foreign Tax Credit Calculation

The AMT for individuals in calculated on Form 6251. Taxpayers who need to determine whether they will have an AMTFTC, will first need to calculate their foreign tax credit for their regular tax. Once this is done, line 34 of the form should be filled in, and if the amount on this line is greater than or equal to the amount on line 31 (see IRS instructions for specifics), then a zero would be entered on line 35 (the AMT line), and the instructions should be reviewed to determine whether the form will need to be attached to the tax return. If the AMT is not owed, line 32 of the form will still need to be filled in, in order to determine whether a taxpayer has an AMTFTC carryback or carryforward.

If the AMT is owed, the FTC may be limited by IRS rules. In general, for purposes of calculating the AMTFTC limitation, foreign-source AMT income (AMTI) is divided by total AMTI. This amount is then multiplied by the tentative minimum tax (and not the regular tax). This calculation must be determined for each separate basket type of income (i.e. general and passive income). FTCs that are not used because of the AMTFTC may be carried forward.

Taxpayers may elect to use regular foreign-source income in the numerator of this equation, provided that it does not exceed total AMTI.

Contact Sherayzen Law Office For Tax Help With Determining AMT, FTC and AMTFTC

Determing your Foreign Tax Credit and Alternative Minumum Tax can involve complex issues and this article only attempts to provide a very general background information that should not be relied upon in making the determination of your specific situation. Rather, you should contact Sherayzen Law Office for legal help with this issue. Our tax firm will help you determine your AMT, FTC and AMTFTC for the relevant tax years as well as provide sound tax planning for the future.