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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.

Will Capital Gains Move Me Into a Higher Tax Bracket?

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A frequently asked tax question is whether capital gains may push a taxpayer into a higher tax bracket. This article will examine some of the tax possibilities with respect to this question.

Background

In general, capital gains are subject to the 0% or 15% capital gain rate. Generally, for 2010, if all of a taxpayer’s taxable income is within either the 10% or 15% tax brackets (and all of the net capital gains are eligible for the 10% or 15% rates), then a taxpayer’s capital gains will qualify for the 0% rate.

In order to calculate tax liability on Schedule D or on the IRS capital gains worksheet, taxable income is reduced by net capital gains and qualified dividends (other than 28% rate gain and unrecaptured Section 1250 gain), leaving ordinary income as a result. In general, capital gains (and qualified dividends) will be tax free to the extent they “fill in” the difference between ordinary income and the top-end of a taxpayer’s filing status. (See examples below).  For tax year 2010, the top-end of the 15% bracket is taxable income of $34,000 for single taxpayers and married filing separately, $45,550 for heads of household, and $68,000 for married filing jointly. Thus, taxpayers will qualify for the 0% rate if none of their taxable income exceeds the top-end of their applicable filing status.

Examples

Please, note that the examples below are for illustrative purpose only and may not apply to your specific fact situation.

1). Taxpayers qualify for the 0% rate

Married filing-jointly taxpayers have ordinary income of $50,000 and net capital gain of $15,000 as their only other source of income. Because the top-end of the 15% bracket for their filing status is taxable income up to $68,000 and their ordinary income added together with their capital gain does not exceed that top-end threshold, the entire $15,000 capital gain will qualify for the 0% rate.

2). Taxpayers qualify for 0% rate on part of their capital gains, and pay at the 15% rate on the rest

Married filing jointly taxpayers have ordinary income of $60,000 and net capital gain of $20,000 as their only other source of income. Because the top-end of the 15% bracket for their filing status is taxable income up to $68,000 and their ordinary income added with their capital gain exceeds the top-end of that threshold, part of their capital gain must be paid at the 15% rate. Specifically, subtracting their ordinary income of $60,000 from the top-end of their filing status bracket of $68,000 leaves $8,000 of capital gains that can qualify for tax free rate. The remainder of their capital gain will be taxed at 15%.

3). Taxpayers do not qualify for the 0% rate

Married filing jointly taxpayers have ordinary income of $75,000 and net capital gain of $5,000 as their only other source of income. Because their ordinary income exceeds the top-end of the 15% bracket for their filing status ($68,000), none of their capital gain will qualify for the special 0% rate. Instead the entire capital gain will be taxed at the 15% rate.

Note that these are the general rules relating to capital gains and tax brackets, but other rules and factors may apply under applicable circumstances. For example, if Section 1250 unrecaptured gain property or capital gains taxed at the 28% rates are involved, the general rules will not apply. Also, deductions and various phaseouts may still be limited even if the taxpayer qualifies for the 0% rate. Additionally, there may be state capital gains tax rates that apply even if the federal rate is 0%.

Therefore, do not try to rely on your own opinion to resolve your capital gains tax questions. Rather, you should review your specific situation with a tax attorney who will help you deal with these complex tax issues.

Contact Sherayzen Law Office to Get Capital Gains Tax Help

Do you have further questions regarding your capital gains and tax liabilities? Contact Sherayzen Law Office at (952) 500-8159 to discuss your tax situation with an experienced tax attorney.