Q: I was wondering if you would be so kind and clarify something for me. I have a rental home that I have rented out for the past 18 months. Prior to that, I lived in the home for eight years. I want to sell it and buy a different rental home.
Do I need to use a 1031 tax free exchange or am I free from capital gains tax because I lived in the property for 2 out of the past 5 years?
You might also need to know that I did claim the income and expenses from the rental property on my federal and state income tax returns, but I didn’t claim the depreciation. Since I did my taxes myself, I didn’t feel comfortable enough to work on the depreciation. Does that add any layer of complication?
A:You lived in your primary residence for 8 years and then rented it out for 18 months; You are now selling your rental home and want to get some idea of the tax implications of an outright sale so you can contrast it with the tax implications of a 1031 exchange.
You plan to purchase another rental property after you sell this one, which is important if you want to use a 1031 exchange, but not necessary for any rollover of capital gains of a personal residence. A 1031 tax deferred exchange process is a means of selling an investment property and deferring paying federal income taxes on the sale of that investment property. But to do it, you have to follow some very strict rules that govern these types of sales.
According to Bill Nemeth, an enrolled agent based in Atlanta, the good news is that you can exclude some or all of the gain from the sale under Section 121 (Married Filing Jointly – up to $500,000 of gain can be excluded).
“I am assuming that when the owner elected to convert your home to rental property, he claimed the rental income and expenses, including depreciation, on Schedule E. The depreciation claimed during the rental period is considered unrecaptured Section 1250 gain and is not eligible for the exclusion. This portion of the gain is reported and taxed up to a maximum rate of 25 percent on Schedule D.”
Nemeth notes if you have substantial capital gains above the 121 exclusion limitations, you have the option to complete a 1031 exchange to defer any balance of capital gains above the 121 exclusion amount, according to IRS Revenue Procedure 2005-14.
But the red flag for your situation is the depreciation you didn’t take on your IRS tax forms.
According to Nemeth, IRS code states that depreciation recapture must be included on depreciation taken or is available to be taken.
“The owner has the option of amending his 2011 and taking the 2011 depreciation in that year (which may be helpful if it creates a lower tax but it depends on the owner’s filing status and total income),” he explained.
You will have to review your return to see if it would be beneficial to you tax-wise. You would then have the 2012 depreciation up thru the month of sale, which would factor into your income for 2012 before the gain calculations.
For real estate investors, here’s a quick overview of depreciation: Your depreciation basis would be the lower of your cost or fair market value on the date you converted your personal home to rental.
Let’s assume your purchase cost is lower at $200,000. Assuming your land value is 30 percent of the total purchase cost, your basis for depreciation would be $140,000.
Rental homes are depreciated over 27.5 years, which means one year of depreciation is 3.63636 percent (1/27.5) times your basis of $140,000 or $5,091 per year.
When it comes to federal income taxes, you can see how things get complicated, especially when you mix personal income tax situations with investments. In your case, the small time you rented your home caused this potentially difficult tax situation and you might need to sit down with a tax professional to determine what will be best for you.
You lived in the home for almost eight of the ten years you owned it. If the profit on the sale was big enough to justify a 1031 exchange, you should know that when you sell the home, you will need to set up the 1031 exchange at that time and you will need to designate a new property that you intend on purchasing within forty-five days of the sale of the home and close on the purchase of that new property within one hundred and eighty days. The rules can be complicated and cumbersome. Make sure you find a reputable 1031 exchange company that can assist you through the process.
For more information, download a free copy of IRS Publication 523 from IRS.gov.