Under the rules of IRC §121, gain on the sale of a personal residence is tax–free up to $500,000 for married taxpayers filing a joint return ($250,000 for single taxpayers) if the taxpayer has owned and lived in the residence for periods of time adding up to two years out of the previous five years.
Subject to exceptions (see below) taxpayers have long known that they could cash out of rental properties "tax-free" under the provisions of IRC §121 relating to the tax-free sale of a personal residence (the Section 121 exclusion). All they needed to do was move into a rental property, live there two years and then sell it "tax-free" as a personal residence. Converting a rental property to a personal residence is not a taxable event.
What if the rental property is not suitable for a taxpayer to want to live in it for two years? The answer is a 1031 Exchange for a property that will be suitable for the taxpayer. Astute real estate investors have also known that they can roll out of an investment property thru a 1031 Exchange and replace with a qualifying residential real estate investment property They then rent it out for a year or so (exchange professionals recommend at least one year) before moving into it. Once they live in it for two or more years (and after owning the property for five years) they are eligible to take the Section 121 exclusion on a subsequent sale.
The five year ownership requirement became effective October 22, 2004 with the American Jobs Creation Act of 2004. The Act imposed a new ownership requirement of five years for property received as replacement property in a 1031 Exchange. The two year residency requirement remained unchanged.
Any depreciation taken on the residence after May 6, 1997 is not eligible for the Section 121 exclusion and must be reported as income even if the home otherwise qualifies for the Section 121 exclusion. This exception applies to rental houses converted to a personal residence and also to any part of a personal residence which has been depreciated (i.e. home office).
Any depreciation taken on the residence prior to May 6, 1997 doesn't count and is not taxed under §121. This rule is helpful for rental properties which were substantially depreciated before 1997 and later converted to a personal residence.
It's worth noting here that this "depreciation recapture" rule applies to depreciation taken on the residence which is being sold without reference to depreciation taken on a rental property which was exchanged for a new residence under IRC Section 1031. Depreciation taken on a previous rental property doesn't carry over to the replacement residence for purposes of this "depreciation recapture" rule under IRC §121.
The Housing Assistance Tax Act of 2008 reduced the benefits of the Section 121 exclusion on the sale of a personal residence. In a nutshell, any "disqualified use" of a residence after January 1, 2009 causes a fraction of the §121 gain to be not qualified for the exclusion. Accordingly, any period of time after January 1, 2009 during which the residence was used for rental purposes is "non qualified use" and any exclusion under IRC §121 must be prorated to determine the part of the gain not eligible for the §121 Exclusion.
This new rule affects rental properties which are converted to a personal residence after May 1, 2009 and is not helpful for rolling over an investment property to a personal residence for purposes of qualifying the residence for a subsequent sale eligible for the Section 121 exclusion. For a detailed explanation of the 2008 tax act, see Housing Assistance Tax Act of 2008 Reduces Benefits of a Tax–Free Personal Residence Sale.
Taxpayers converting investment property to their personal residence thru a 1031 Exchange with subsequent conversion of the replacement property to a personal residence can still take advantage of the Section 121 exclusion for sale of a personal residence subject to the exceptions listed above. Obviously, this tax planning possibility is getting more complicated but is still appealing to many taxpayers. Please contact us at 888-367-1031 or via email at for more information.
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