One of the great benefits of home ownership is the ability to save money on your taxes through the deduction of mortgage interest, loan fees, and improvements, not to mention, the opportunity to exclude up to $500,000.00 of taxable capital gains on the sale of your primary residence.
Prior to 1997, the IRS permitted a one-time capital gains exclusion of $125,000.00 for homeowners 55 years and older on the sale of their personal residence. The 1997 Taxpayer’s Relief Act amended this exclusion to affect any sale of a principal residence after May 7, 1997. Single tax filers can now exclude up to $250,000.00 in capital gain, while couples filing joint returns can exclude up to $500,000.00.
In order to qualify for the exclusion the following rules apply:
1) For couples, both spouses must occupy the home for at least two out of the last five years. (These years do not have to be consecutive)
2) For individuals, the person must occupy the home for at least two out of the last five years. (These years do not have to be consecutive)
3) There is no limit on the number of times a taxpayer can take advantage of the exclusion.
4) Any gains above the $250,000.00 or $500,000.00 exclusion amounts will be taxed at the appropriate capital gains rate.
5) The exclusion does not apply to vacation or second homes.
In the event that a taxpayer has multiple homes, he or she may choose which home is designated as their principal residence. It is important, however, to make sure that you have proper documentation in place to support your decision. Some of the key questions to ask yourself include:
1) Do you live in the house at least six months out of the year?
2) Is your place of business or employment near your principal residence?
3) Do other family members live in the same house?
4) Is the home’s address used on your tax returns, driver’s license, and voter registration?
CONVERTING YOUR PRIMARY RESIDENCE TO A RENTAL PROPERTY
As indicated above, the ability to exclude up to $500,000.00 in capital gains tax on the sale of your personal residence is a huge benefit to you as a property owner. The savings you realize can be used for other important purposes such as retirement, education, or other investments.
Sometimes the market conditions are not favorable for selling your personal residence. You may decide to hold off selling and convert your residence into a rental property until the market improves. While this may appear to be a reasonable alternative, you need to be aware of the tax ramifications in doing so.
If you rent the property for more than three out of the last five years, you no longer qualify for the principal residence exclusion of $250,000.00 (for an individual filer) or $500,000.00 (for a couple filing joint). This may not be a material issue if your capital gain is minimal. However, if your gain is substantial, you will pay an unnecessary capital gains tax.
On the other hand, converting your personal residence to a rental property in a down market may be something to consider as losses on the sale of your personal residence are not deductable while losses on a rental property are.
As is the case for all tax related issues, you should consult a professional in this area.
CONVERTING A RENTAL PROPERTY TO YOUR PERSONAL RESIDENCE
A good investment strategy might be to move in to a rental property, live there for two years, and then sell it, taking the personal residence exclusion of either $500,000.00 (for couples filing joint) or $250,000.00 (for individual tax filers). This type of strategy repeated will result in significant tax savings over a period of time.