Landlords thinking of converting rental to primary:

[calmloki]

This from IPX exchange services:

"Attention Primary Residence and Investor Homeowners...

UPDATED: Amendment to §121 may affect §1031 Exchange Planning
The Housing Assistance Tax Act of 2008, signed by President Bush on July 30, 2008, includes a modification to the Section121 exclusion of gain on the sale of a primary residence. This modification may affect taxpayers who exchange into a residential property, and then later convert the property to a personal residence, as explained below.
Under Code Section 121, a taxpayer can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale of a principal (primary) residence if they have owned and occupied the residence for two years during the five year period preceding the date of sale. Gain related to depreciation deductions taken on the property since May 6, 1997 is not eligible for exclusion.
Effective January 1, 2009, the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.” Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence. This change applies to use as a second home as well as a rental.
How does this affect 1031 planning? Suppose the taxpayer exchanged into the residence and rented it for four years, and then moved into it and lived in it for two years. The taxpayer then sold the residence and realized $300,000 of gain. Under prior law, the taxpayer would be eligible for the full $250,000 exclusion and would pay tax on $50,000. Under the new law, the exclusion would have to be prorated as follows (the example does not take into account deprecation taken after May, 1997, which is taxable anyway).
• Four-sixths (4 out of 6 years) of the gain, or $200,000, would be ineligible for the $250,000 exclusion.

• Two-sixths (2 out of 6 years) of the gain, or $100,000, would be eligible for the exclusion.
Importantly, nonqualified use prior to January 1, 2009 is not taken into account in the allocation for the nonqualified use period (but is taken account for the ownership period). Thus, suppose the taxpayer had exchanged into the property in 2007, and rented for 3 years till 2010 prior to the conversion to a primary residence. If the taxpayer sold the residence in 2013 after three years of primary residential use, only the 2009 rental period would be considered in the allocation for the nonqualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion.
In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to time periods after the conversion out of personal residence use. Thus, if a taxpayer converts a primary residence to a rental and never moves back in, and otherwise meets the two out of five year test under Section 121, the taxpayer is eligible for the full $250,000 exclusion when the rental is sold. This rule only applies to non qualified use periods within the 5 year look back period of Section 121(a) after the last date the property is used as a principal residence. Therefore, if the taxpayer used the property as a principal residence in year one and year two, then rented the property for years three and four, and then used it as a principal residence in year five, the allocation rules would apply and only three-fifths (3 out of 5 years) of the gain would be eligible for the exclusion".

This is different from the plan i had under my understanding of current law of being able to do a 1031 of a rental into a single family residence with intent to rent, and actually renting it out for a year, and then converting to our personal house, living in it for at least two of the next four years, and then being able to exclude $250k of capital gains on it's sale, but paying tax on any depreciated amount. Still a pretty good exit strategy for a rental owner, but a bit less good than it was. Worth checking on - first i had heard of it.

[wexeter]

Yes, the change was included in The Housing and Economic Recover Act of 2008 that just past last month. The change was designed to close a loop hole that investors found by combining the 1031 exchange with the 121 exclusion.

[Martha]

Bummer. Now that I am out of the law biz, I missed this. Not reading the advance sheets!

[tryan]

So if you're having trouble selling and decide to rent out for a couple years you're loosing a sizable piece of the exemption ... perhaps MORE than the rents will ever bring in! Temps you to not declare the rental income ... just have the thing "sit vacant".

That's a tough pill to swallow.

[wexeter]

Rental usage BEFORE the property is used as a PRIMARY residence will count against you, but rental usage AFTER the property was used as a primary residence will not hurt you.

Here is a more detailed analysis: Section 121: Changes to Section 121 ("121 Exclusions") by the Housing and Economic Recovery Act of 2008

Let me know if you have any further questions.

[outtarentals]

[quote=wexeter;708351]Rental usage BEFORE the property is used as a PRIMARY residence will count against you, but rental usage AFTER the property was used as a primary residence will not hurt you. quote]


So....does rental (unqualified) usage before Jan 1st, 2009 count - or is that grandfathered and forgiven?

Example: On Jan 1st, 2009 we move into a rental house we've owned and rented for 3+ years. (It was never involved in a 1031 exchange.) We live there for 2 years then sell. Can we claim the $250K - $500K exemption?

By the way....thanks for this.

[Purron]

How might the tax law apply to this situation:

Purchased home in 1977 lived in it as primary residence until 1997. Let brother live in it rent free for 4 years while he got his life back together, then rented from 2002 to 2009, moved back in for 2 years, then sold. How much of the $250K/$500K exclusion from capital gains would be lost under the revised tax rules?

Calmloki, so glad you made us aware of this.

[wexeter]

So....does rental (unqualified) usage before Jan 1st, 2009 count - or is that grandfathered and forgiven?

Example: On Jan 1st, 2009 we move into a rental house we've owned and rented for 3+ years. (It was never involved in a 1031 exchange.) We live there for 2 years then sell. Can we claim the $250K - $500K exemption?

Great question. Congress actually gave us a very generous transition period. Any non-qualified use prior to 01/01/2009 such as rental usage is ignored. So, if you move into the property on 01/01/2009 as your primary residence the new law will not affect you. 100% of the usage will be considered to be your primary residence and you will receive 100% of your 121 exclusion.

[ChuckvB]

Recently I moved out of my Primary residence as I left one job for another. I was in my Primary for 15 years until July 2008. I rented the house in Nov. 2008 because the market is so bad in Phoenix I decided to try to wait it out a bit. I plan to rent it no more than two years before I sell or move back into the house. If I sell, no problem I get the full deduction. If I move in I guess when I finally do sell I will loose 2/(total years owned) of the $250K. Right? That may be okay in the end. But for other purposes when does the house become a rental property? The day it's rented or when I start trying to rent it? Can I claim for depreciation cost I put into the house to repair things to get it ready to be rented even though it was not at the time?

[Martha]

Lots of questions there Chuck. I suggest reading this publication from the IRS: http://www.irs.gov/pub/irs-pdf/p527.pdf

Depreciation is a different concept from what expenses are deductible. Depreciation is taking the value of the improvements (like the building and appliances) and deducting a portion over time consistent with IRS formulas. You will have to pay taxes on the depreciation taken when you sell the home, even if you go back and live in it. This is often called "recapture." You also may lose part of your 250,000 exclusion, consistent with Calmloki's post above.

[ChuckvB]

Thank Martha
I think I understand the possible loss of some of the section 121 exclusion. But as I'm doing taxes this year I want to understand some key rules so we don't make a costly mistake. I can't find the answer to some of these questions below.

For instance:
When does a property become a "Rental Property" I moved out in July but didn't get it rented (I was trying) until Nov. 2008?

As I rented a place in Virginia in August 2008 I guess it became my Primary residence (I was employed there too). When does my clock start ticking for selling before the three years are up. Is it the July date when I moved out or the Nov. date when it was rented? Can I choose which one?
And the repairs I made (Not improvements) before it was rented in 2008 for renting it out, can I claim those as repairs as deductions?

[Nords]

Quote:

Originally Posted by Martha You will have to pay taxes on the depreciation taken when you sell the home, even if you go back and live in it. This is often called "recapture." You also may lose part of your 250,000 exclusion, consistent with Calmloki's post above.

Not only that, but the IRS will expect depreciation capture taxes to be paid whether or not the landlord actually took the depreciation.

Quote:

Originally Posted by ChuckvB For instance: When does a property become a "Rental Property" I moved out in July but didn't get it rented (I was trying) until Nov. 2008?

You have a little flexibility here. The residence becomes a rental when you made the decision to try to rent it out.

You may have made that decision when you left in July or when you moved into another primary residence in August. You could also have decided to call it a rental in November but then you wouldn't get much benefit for all those months of vacancy.

Unless you're committing massive tax evasion on your return, with multiple offenses, the IRS will not quibble with whatever one of the three months you choose.

Quote:

Originally Posted by ChuckvB When does my clock start ticking for selling before the three years are up. Is it the July date when I moved out or the Nov. date when it was rented? Can I choose which one?

Not sure about that one... never had to deal with it. I'd suspect that it was the date you made the decision that the residence was a rental, but I'd be applying logic to IRS tax rulings.

Quote:

Originally Posted by ChuckvB And the repairs I made (Not improvements) before it was rented in 2008 for renting it out, can I claim those as repairs as deductions?

There's a certain amount of flexibility in deducting the expenses of getting a property ready to rent. However I don't remember if that can be applied to expenses incurred before you decided to call the property a rental. You're essentially forced to choose between maximizing deductions (calling it a rental as early as possible) and extending the three-year deadline (calling it a rental as late as possible).

In addition to the pub referenced by Martha, you may also want to try a library or bookstore copy of "J.K. Lasser's Your Income Tax" and read the chapter on deciding when a rental is a rental.

[ChuckvB]

Thanks for all the input. I if I decide to sell in two years then and I can sell in less than six months then the July date will probably maximize my deductions. But I need to read more on that start date of the three year clock so I don't think I have more time than I really do.

[tryan]

Yeah, one thing for sure ... if you plan to sell : don't miss the tax free sale.

[ChuckvB]

Quote:

Originally Posted by tryan Yeah, one thing for sure ... if you plan to sell : don't miss the tax free sale.

I assume you mean the 121 section $500K deal. Yes I won't jeopardize that. but under the new rules I could loose some if I move back in which could happen.

[tryan]

Yeah 121 section .... I am reminded of a good friend who basically fell asleep at the switch - rented too long - then got hit with a 70k tax bill. The gain could have tax free if had sold a bit earlier.

With those numbers no amount of rent was worth it. Point being, it's probably better to sell tax free claiming residency 2 of 5 years rather than hold it hoping to move back to it. The tax savings could rent you a nice place for a very long time.

[ChuckvB]

In my case if I move back in I would be at worst at a 2 years rented out of 20, loosing 10% of my $500K or $50K in deduction. But if I sell I pay reality costs of ~6% to 7% on lets say $700K or ~$45K real dollars. Thus If I move back in verses selling it's a better move. If I could I would sell today the but market in Phoenix is dismal. If I move back in, in five years I would gain $$ in appreciation. (I'm assuming a recovery of the market there by then. That is a risk but these are cycles.

In the best case I'm hoping to sell in two years and my current employer to extend my date that they will cover my selling expenses. Hopefully I get a quicker sell at a better price than today and no selling cost.

[ChuckvB]

There is this part of the new legislation. "...In other words, a primary residence that is subsequently converted into investment property will still qualify for the tax free exclusion under Section 121 provided the property is sold no later than three (3) years after its conversion to investment property. The property will no longer qualify for the 121 exclusion once it has been held by the homeowner as investment property beyond the three (3) year window...." If I move back in for three years I'm I again qualified for the 121 exclusion? Would renting it for two years in the middle of an owing period kill the exclusion?