Must tax on capital gains on the main residence converted into a rental?
Dear tax speech,
I bought a property in 2009 for $ 235,000 and made improvements worth $ 50,000. It was our primary residence from July 2009 to April 2015. Since May 2015, it has become a rental property. Now we are thinking of putting the rental property on the market for around $ 450,000 and hope it sells in the next 5-6 months. I know I am looking at capital gains over profit ($ 165,000). But based on the IRS documentation, since this was our primary residence for at least 2 years out of the last 5 years from the date of sale, I am eligible for the exclusion of this surplus value (i.e. I am not supposed to pay any surplus value).
Is my conclusion correct? Or am I still liable for a certain percentage of capital gains since this is a rental property for over a year now? If it helps, my spouse and I jointly file tax returns and are based in Texas. Thanking you in advance.
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Since your home has been converted to rental property, you may need to report some of the gain as income on your tax return as a result of the sale.
You are correct that you will follow the IRS rule to exclude part of the gain on the sale of the property because you owned the house and it has been used as your primary residence for 2 of the past 5 years. However, since it was used part of the time as a rental property, additional rules come into play now.
When you converted your home to rental property, along with your other rental expenses from property taxes, mortgage interest, insurance, etc., you were also allowed to claim capital cost allowance which allows you to deduct the cost of the property. over time. When the property is sold, you may need to “recoup” some or all of the depreciation at regular tax rates on your tax return. The balance of the taxable capital gain on the disposal which is not taxed at the ordinary rate of income tax is taxed more favorably as a capital gain.
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3 steps to follow
So how do you understand all this? Well, that requires several calculations and a lot of patience on your part:
- Calculate your overall gain on the sale of the property.
- Calculate the “taxable” gain on the sale of the property. This is where the division between personal home use and rental use is made.
- Determine how much of the gain is taxable as ordinary income and what is taxable as capital gains income.
IRS publication 523, Selling Your Home, has worksheets for the 3 steps listed above, so it should be added to your reading list – and do it ASAP.
Take advantage of suspended losses
Also, have you ever owned a rental property in which you suffered losses? If this is the case, it’s important to note that if the rules for passive investment activities for rental property have resulted in âhanging lossesâ in previous years, you can use them on your tax return. These suspended losses would have been tracked on Form 8582, Passive Activity Loss Limitations.
You may want to consider hiring a qualified tax professional to help you with tax filing for the sale of the property, as it gets a bit complicated and spreadsheets are not for the faint of heart.
Thanks for the great question and all the best to you!
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