Tax Strategy - Converting Your Primary Residence To a Rental

Did you know you could potentially avoid paying taxes on hundreds of thousands of dollars from the sale of your primary residence? By strategically converting your primary residence into a rental property and then selling it, you can leverage both Section 121 & Section 1031 of the Internal Revenue Code to significantly reduce your tax burden. This clever real estate maneuver allows you to exclude a portion of the gain and defer the rest, maximizing your financial benefits.

Many people are aware of the advantages of Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence ($250,000 for a single taxpayer). Although this amount of gain is generous in most areas of the country, in some states homeowners receive more than $500,000 of profit when they sell their home. That additional profit is subject to federal and state capital gains tax and net investment income tax (Medicare tax).

 What is much less understood in the real estate world is that a homeowner can avoid paying all of the tax on their home by converting it to a rental. Once the home is converted to a rental, the owners can sell it and use both the Section 121 exclusion of gain and the Section 1031 deferral of gain provisions to exclude some of the gain and defer paying tax on the rest. Most tax advisors recommend renting the home for at least two years to establish it as a rental, but if you rent it for too long, you could lose the ability to benefit from the Section 121 exclusion, since that provision requires that you have lived in the home as your primary residence for at least two of the past five years. 

 For example:

John and Mary Smith have lived in their home for twenty years. They acquired it for $100,000 and it is now worth $1 million, so if sold, they would have $900,000 of gain. If they sell it without converting it to a rental, they would be able to exclude $500,000 of gain but would have to pay capital gains tax on the additional $400,000 of gain.

 John and Mary decide, however, to convert their property to a rental. After renting it for two years, they sell it for $1 million. Since they used the home as their primary residence at least two of the past five years, they can exclude $500,000 of the gain. They can then use the remaining funds to acquire replacement investment property in a 1031 exchange and defer paying tax on the balance of the gain. To accomplish this, they must set up the 1031 exchange prior to closing on the sale of the property. 

In order to completely defer the remaining gain, the traditional rule is that the investor must acquire replacement property with a fair market value equal to or greater than the relinquished property and must invest all of the equity from the relinquished property into the replacement property. When gain has been excluded under Section 121, however, the amount of value and equity required to invest in the replacement property is reduced by the amount of gain that was excluded under Section 121. 

 Homeowners who decide to combine a sale of their primary residence with a 1031 exchange need to comply with all of the rules of Sections 121 and 1031 in order for this to work. Revenue Procedure 2005-14 explains how the two statutes may be combined for one property. This ruling includes not only the situation mentioned above, but also a sale of a personal residence with a home office or separate guest house that is rented.

 Some of the requirements to keep in mind are:

 To take advantage of the $500,000 exclusion ($250,000 for single Taxpayers), you must own and live in your home as your primary residence for at least two of the past five years;

• You can only take advantage of the Section 121 exclusion once every two years;

• Section 121 doesn't allow you to exclude any gain attributable to depreciation deductions taken since May 6, 1997, but that gain can be deferred under Section 1031; and

• To take advantage of the deferral of gain under Section 1031, the property you sell and the property you acquire must at the time of the exchange be used in connection with your business or held for investment.

This article discusses some general concepts, but you should consult with your tax advisor.