Ask Liz Weston

Get smart with your money

home sale exclusion

Q&A: Closing the case on the couple moving into their rental property

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Dear Liz: You recently answered a question from a couple who wanted to move into their rental property, make it their primary residence and use the $500,000 home sale exclusion if they sold the property after living there for two years. You should have made it clearer that not all of the gains on the property would qualify for the exclusion.

Answer: Quite right. In 2008, Congress closed the loophole that allowed people to exclude all the gains when they turn rental property into their primary residence. So the couple would not be able to count the gain that occurred between 2009 and whenever they move in. They would, however, be allowed to include the gain from 1988, when they bought the property, through 2008, as well as any increase in value after they move in if they live in the house at least two years, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

In some parts of the country, there may not be enough gains from those two periods to qualify for the full $250,000-per-owner exclusion, especially after accounting for the depreciation recapture, which requires landlords to pay back the depreciation tax break when they sell a rental property.

In higher-cost areas, however, there still could be more than $500,000 of qualifying gains, Luscombe says.

Q&A: When landlords move in to an old rental, are tax breaks part of the deal?

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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.

Q&A: When an inherited house gets sold, it pays to know the tax rules

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Dear Liz: My sister and I inherited a house from our mom in 2003. Back then, it was appraised at close to $500,000. It’s now worth $1.3 million and we want to sell and split the profits. My sister has lived in the house since Mom passed. Approximately what would the tax liability be?

Answer: You’ll determine the potentially taxable profit by subtracting the tax basis — the amount the house was appraised for at your mother’s death, plus any qualifying improvements — from the sale proceeds. Your sister can exempt $250,000 of her share of the profits, since she has owned and lived in the house for two of the previous five years. If her share of the profit was $400,000, for example, she would owe long-term capital gains taxes on $150,000 of that.

As a non-occupant, you wouldn’t have the option to exempt any of the profit, so you would owe long-term capital gains taxes on your entire $400,000 share. Long-term capital gains rates depend on your income, but the federal rate is 15% for most.

Q&A: Complicated condo question

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Dear Liz: You recently answered a question about gifting a condo. I understood the first part of your answer: If the person receiving the gift lives in the condo for two of the last five years, then there is no capital gains exposure. The second part of your answer is a little confusing to me. You wrote, “However, her taxable gain would be based on your tax basis in the property: basically what you paid for the home, plus any qualifying improvements.” So, if my mother gifted her condo to me and she paid $50,000 for it 40 years ago, and the condo today is selling for $250,000, what is my capital gains exposure? To keep it simple, assume no capital improvements or other factors.

Answer: Living in and owning a home for two of the previous five years does not erase someone’s capital gains exposure. Instead, they’re entitled to exclude up to $250,000 of home sale gains from their income.

In the case you describe, your potentially taxable capital gain would be $200,000. That’s the selling price of $250,000 minus your mother’s tax basis (which is now your tax basis) of $50,000.

If you owned and lived in the home at least two of the previous five years, your exclusion would more than offset your gain, so the home sale wouldn’t be taxable. If you didn’t make it to the two-year mark, you could get a partial exemption under certain circumstances, such as a work- or health-related move. For more details, see IRS Publication 523, “Selling Your Home.”