Use the primary residence gain exemption to your advantage by moving into your rental property
Let’s first examine what happens if there is no change of use. When an owner sells investment real estate at a gain, unless they do a 1031 exchange, they must pay the tax. When a owner sells an appreciated primary residence that they have lived in for more than two years, they only have to recognize gain that exceeds the Section 121 (§121) gain exclusion of $500,000 for couples filing jointly or $250,000 for individual filers.
What are the ramifications if a owner wants to sell their primary residence and move into their appreciated rental property? Assuming the gain on the sale is less than $500,000, no tax is due on this profit. Also, no tax is triggered in the year the change of use (moving into their rental property) takes place. The only substantive change is where the property is reported on the tax return- moved from schedule E to Schedule A. But there may be a very different positive tax outcome when the property is eventually sold.
The best way to analyze this question and the outcome is to first determine if you are looking backwards for your analysis or if you are doing forward planning.
Looking backwards example: John and Katie bought a beautiful beachfront rental home on January 1,2006 and decided three years later to change the use by moving into the property and using it as their primary residence (January 1, 2009). If they sell the property after two years of living in it, they would be entitled to the $500,000 gain exemption under §121. The rule states that if you have owned the property for five years and use it as your primary residence for at least two out of the five years then the §121 exclusion will apply.
But the timeframe of this example is critical because if there had been any rental activity after December 31, 2008, then a pro-rata formula would have to be applied to the gain rendering some of the gain as taxable investment gain and some of the gain qualified for the §121 exclusion. This rule change was enacted into law under the Housing and Economic Recovery Act of 2008.
Looking forward example: John and Katie buy a beautiful beachfront rental home on January 1, 2010. They have already given their tenants notice that they will not be renewing the lease after December 31, 2012 because they plan to move into the property and claim it as their primary residence. They have already put their current home on the market and feel comfortable that it will sell by the end of the year. They think there will be approximately $400,000 of gain. They are looking forward to not having to pay any tax because it is less than the $500,000 gain exclusion allowed in §121.
But they are wondering what will happen going forward when they eventually decide to sell the beach house. The tax consequences will primarily be controlled by the number of years they use the beach house as their primary residence. The pro-rata formula that became law in 2008 will apply to their situation because there was rental activity as of January 1, 2009. The gain on the sale of their home after January 1, 2013 will be allocated based on the time the property was used as their personal residence (qualified use) versus rental property (non-qualified use). If after three years of using the beach house as their home, they sell it and the closing takes place December 31, 2015, they will have owned the property for a total of six years and had three years of qualified use and three years of non-qualified use. Therefore, if there is a $600,000 total gain on sale, half of the gain ($300,000) will be excluded under Section 121 and the other half of the gain will be considered long-term capital gain under the investment sale rules.
But if John and Katie live in their beach home until the end of 2018 (six years) the math would change. If they sell the property on December 31, 2018 then they will have owned the property for a total of nine years, six of which were primary residence (6/9ths) use and three of which were investment property use (3/9ths). Therefore, if there is a $600,000 gain at sale, 2/3rds of the gain, $400,000, would be excluded under the primary residence rules and remaining $200,000 would be taxable investment gain. The longer the beachfront property is their home, the greater the potential tax benefit.