Dear Liz: My husband and I bought a single-family home as a rental property in 1988. We paid $135,000. The tenants moved out in February and we are doing major upgrades now. If we moved into the property and sold it after two years, would the first $500,000 of gain be excluded from income tax? The property is under our family trust and our two daughters are successor co-trustees.
Answer: Generally speaking, a former rental property can qualify for the home sale exclusion as long as the owners claim it as their primary residence for at least two of the five years before the sale.
The home could still be subject to depreciation recapture, however, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. You probably deducted depreciation on the rental over the years — basically reflecting the wear and tear on the property. The IRS typically requires that tax break to be paid back when the property is sold. You won’t be able to exclude the part of the gain that’s equal to any depreciation deduction allowed or taken after May 6, 1997, Luscombe says.
If your trust is a revocable living trust, which is designed to avoid probate, your ability to take the home sale exclusion won’t be affected. Other types of revocable trusts may require the home to be taken out of the trust before it’s sold, Luscombe says. If it’s an irrevocable trust, the sale of the home generally would not qualify for the home sale exclusion, he says.
You should discuss this with a tax expert before proceeding, and consider reviewing other options for reducing taxes. For example, if you kept this home until death and bequeathed it to your heirs, there probably wouldn’t be any tax on the appreciation that occurred during your lifetimes.
The response to the question in the LA Times appeared to indicate that the full exclusion of $500k would be allowed. Based on tax law, this is not the case. The Housing Tax Act of 2008 closed the “loophole” that allowed for the converting of a rental property into a primary residence for two years and excluding 100% of the home sale exclusion of capital gain. Internal Revenue Code Section 121(b)(4) limits the exclusion of capital gains for property that was converted from a rental property to a primary residence. The exclusion is only available for periods during which the property was used as a primary residence; any other time since January 1, 2009 that the property was not used as a primary residence is considered “nonqualifying use”. To the extent that gains are allocable to periods of nonqualifying use, those gains are not eligible for exclusion.
Thanks. You’re right that I should have made that clearer. I’ll address it in a future column.