By Jason Watson (Google+)
Well, it can actually help you quite a bit. If your rental property has increased in value over the years, gains on recaptured depreciation is taxed at your ordinary tax rate up to 25%, while the remaining gains are taxed at your capital gains rate (either 0% or 15% depending on your tax bracket). If your marginal rate is 10% or 15%, you pay 0% in capital gains. If your marginal rate is 25% or higher you pay 15% in capital gains. It bumps up again at 35% and 39.6%.
But, if you live in the property as your personal residence for two out of the last five years, you might be able to use the $250,000 exemption (or $500,000 if you are married and filing jointly) to shelter the capital gains tax as outlined in IRC Section 121. And you don’t necessarily have to live in the property for two years in a row- the 24 months is an aggregated number.
The Housing Assistance Act of 2008 changed the way we look at the exclusion. A calculus now occurs between qualified and non-qualified use. There are two scenarios to muddy the waters.
Scenario A – You buy a house January 1 2009 and live in it for two years. You then move out of state, rent it out and sell it January 1 2014 (five years later). You can exclude your gain up to the exclusion limit without proration.
Scenario B – You buy a house January 1 2009, live in it for two years, rent it out for two years, then move back in. You sell it January 1 2014. You can only exclude a pro-rated amount of the gain.
Some numbers, shall we? We are foregoing the recapture of depreciation for simplification.
| Scenario A | Scenario B | |
| Purchase Price | $200,000 | $200,000 |
| Sell Price | $300,00 | $300,000 |
| Primary Residence | 24 months | 36 months |
| Gain | $100,000 | $100,000 |
| Exclusion % | 100% | 40% |
| Capital Gains | $0 | $60,000 |
The difference between Scenario A and Scenario B lies in the use as a primary residence after making it a rental. Seems odd, but that is the current IRS rule. Straight out of the IRS Publication 523 are these words-
Because the period of nonqualified use in Scenario A does not include any part of the 5-year period after the last date you lived in the house, you have no period of nonqualified use. Because you met the ownership and use tests, you can exclude the gain up to $250,000.
So before you have Home Depot install that ugly carpeting, you might have to live with your flooring choice when you move back in.
If you lived in the home for fewer than 24 months, you can prorate the exclusion amount if you had to sell due to change in place of employment, health or unforeseen circumstances. Here’s the link to the IRS on the maximum capital gains exclusion.
This stuff can get really tricky, and tax planning is a must. Please let us help! And now that homes are back to appreciating this is becoming more important than ever. This is not limited to just rentals- vacation homes and second homes now have the qualified use versus nonqualified use testing.
A note about depreciation- Your total gains are comprised of selling price minus adjusted cost basis. Adjusted cost basis includes depreciation deducted or depreciation allowed. So your overall gain is comprised of recaptured depreciation and capital gains. The exclusion only applies to capital gains.
Another side note- since land is not depreciated, there is some grey area to limit or reduce the amount of depreciation recapture in transactions that involve an increase in LAND value over the structure. While building materials increase, typically the location’s attractiveness is helping the bump in value. More discussion is required.