Tax Deduction on Sale of Primary Residence

Q: I have a tricky question for you. I am supposed to rent a friend’s house and we have come to this bump in the road.
 

Because she wants to sell her house in 18 months to two years, she is worried about paying capital gains tax.

From doing my research, I know that because she has lived in the house as her primary residence for 2 out of the past 5 years, she can rent for 2 years and she’d be okay tax-wise.

Our question has to do with the 1-bedroom apartment that is in her home. She has had her home for 20 years and up until 2 years ago, she had the apartment rented. But she stopped renting it and uses the whole property as her primary residence.

She does not want to pay capital gains on the sale of the property. If I rent the house, I would live in the house not the rental apartment.

A: For starters, when a person sells his or her home, and the person has used the property as their primary residence for at least 2 out of the last 5 years, he or she doesn’t have to pay any tax to the federal government on the first $250,000 of profit (up to $500,000 if the owners are married).

In your friend’s case, she is free to sell the home now and would not have to pay tax on her gains of sale up to $250,000. If she was married, she could exclude $500,000 in gains.

The trick to your question is what is going to happen if she rents the home to you for 2 years. If she can still say that she lived in the entire property for two out of the last five years, she should be okay even if once again turns into a landlord.

While she may not owe capital gains tax on the sale of the property, she may have to recapture any depreciation she took on the 1-bedroom rental through the years.

And, if she takes depreciation on the entire property while she rents it to you, she may have additional taxes to pay when she sells.

While she should be able to exclude most of the tax from the sale of the property, she should speak to an accountant to determine whether her timing will satisfy the IRS and what, if any, obligation she has relating to any depreciation taken for the building in the past.

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