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Old 04-22-2014, 04:03 AM
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Protect Capital Gain Exclusion when converting to rental

I have owned my home since 1989 and I am sitting on a huge capital gain. I don't want to sell the home but I have rented it for the past two years while I have been working overseas.

I read that you can exclude capital gains if the property has been your primary residence at least three of the last five years. So I am worried - if I rent my home for another year have I lost my exclusion on 20+ years of capital gain - over $200,000? If so I would be better off selling it! Can I start a property management company and sell the house to my own company to protect all that gain from tax?

I would prefer to keep the house and probably make it my personal residence again a few years from now. What are my options?



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Old 04-22-2014, 12:56 PM
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Originally Posted by smokyfied57 View Post

#1;I read that you can exclude capital gains if the property has been your primary residence at least three of the last five years.



#2; So I am worried - if I rent my home for another year have I lost my exclusion on 20+ years of capital gain - over $200,000?



#3; If so I would be better off selling it! Can I start a property management company and sell the house to my own company to protect all that gain from tax?

#4;I would prefer to keep the house and probably make it my personal residence again a few years from now. What are my options?
#1;at least 2 of the last 5 years;our gross income shall not include cap.gain from the sale /exchange(biz/trade pty) of
property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by yu as your principal residence for periods aggregating 2 years or more.


#2;No; you are required to have owned and lived in the real property as your primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years) in order to qualify for the 121 exclusion. The 24 months does not have to be consecutive; however, you can no longer take the full tax free exclusion under Section 121 as the property was held and used for non-qualified use, as rental home I mean, prior to it being held and used as a primary residence (qualified use). So, the capital gain resulting from the sale of the property will be allocated between qualified and non-qualified use periods based upon the amount of time the property was held and used for qualified versus non-qualified use. The amount of your LTCG exemption ‘d be decreased as you need to recapture serc 1250 depreciation taken on the rental pty in the previously years and you must recapture the depreciation as ordinary gain on the sale of the home. If your marginal; tax rate is 25% or higher than then the accumulated depre’d be taxed at 25% Simply say your excludible LTCG(after subtractionof nonqualified portion) is $200K and the amount of the accumulated depre on the rental pty was $20K then you need to pay tax of $5K;$20K*25%(as I assume your tax rate is 25% or higher), and then you can exclude only $180K;$200K-$20K. However, non-qualified use after the property was held and used as a primary residence will not count against you as long as you still qualiy for the 121 exclusion. Any and all non-qualified use of the property prior to January 1, 2009 will not be taken into account and is ignored for 121 exclusion treatment; only the non-qualified use of the property after December 31, 2008 will affect homeowners.
For example, assume that you buy your property on January 1, 2009 for $400K and leases it out for two years. you claims$20K of depreciation deductions for those two years. On January 1, 2011, you convert the property and begin to use the property as your primary residence. You move out of your property on January 1, 2013, and subsequently sell it for $700K on January 1, 2014.The period from 2009 through 2010 is non-qualified use of the property because it was held as investment (rental) property. The year 2013, after you moved out, is treated as qualified use of the property .Out of the $300K; I mean $700K-$400K capital gain, 40 percent or 2/5ths (two years out of five years owned), or $120K , is not eligible for the tax free exclusion. The balance of the capital gain, or $180K, may be excluded tax free under Section 121. The $20,000 gain attributable to the depreciation deductions is recaptured taxed at 25%(if your tax rate is 25% or higher), as required under current law.to sum it up, as your tax rate is 25% then 15% of gain tax’d be applied to $120K while zero tax on $160K and 25% of tax would be applied to $20K sec 1250 recapture.


#3;IRS has chosen not to challenge this particular transaction for public policy reasons or, perhaps, because it knows that there is a loophole and it does not want to bring any attention. That said, what you contemplate appears to be entirely legal, as long as you do not retain any remainder interest. I can see how a court could determine a sale by a taxpayer to a wholly-owned corporation as a remainder interest, since in substance, ownership has not substantively transfered to a bona fide third party. In my view, this is the primary risk.So I guess it depends;


#4; as mentioned above, the 121 exclusion allows you to exclude capital gains but not depreciation recapture from your taxable income when you sell your primary residence that was also held as an investment property. The depreciation recapture would be recognized in the year the primary residence is sold even if you qualify for the 121 exclusion.So aslongas you hold it as your primary home, you do not need to recapture the sec 1250 depreciaiton, meaning you do not need to pay tax at 25% on the accumulated depreciation until you sell it.
NOTE:assume that Your primary residence is converted into rental property. you should hold the property as rentalproperty for at least 12 months in order to prove you had the intent to hold the property for investment use and qualify for 1031 exchange treatment. you can then sell the rental property and take the 121 exclusion (providedyou qualify for the 121 exclusion) and you can complete a 1031 exchange to defer the balance of the capital gains not excluded under Section 121.
If your rental property that was acquired as part of a prior 1031 exchange is converted into a primary residence. you convert the rental property into your primary residence. You must live in the property for at least 24 months in order to qualify for the 121 exclusion. Because the rental property was part of a prior 1031 exchange you must also have owned the property for at least five years in order to take advantage of the 121 exclusion. You can then sell the primary residence and take the 121 exclusion.
Rental property that was never part of a prior 1031 exchange is converted into a primary residence. you convert the rental property into your primary residence. you must live in the property for at least 24 months in order to qualify for the 121 exclusion. you can then sell the primary residence and take the 121 exclusion



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