Congress has made some very important changes to the home sale. In both cases, timing and careful records of that timing are crucial.
The Primary Residence Income Exclusion is $250,000 for a single tax filer and $500,000 for married filing jointly; no small amount. Generally, use of the exclusion requires that you own and use the property as your principal residence for periods totaling two out of five years before its sale. This means that you can exclude the gain from the sale of your home up to the exclusion amount. In other words, you can have home appreciation income that is not taxed. You can claim this exclusion once very two years.
The Mortgage Forgiveness Debt Relief Act of 2007 allows a surviving spouse to continue to use the $500,000 exclusion if the jointly owned residence is sold within two years after the death of the individual's spouse.
The Two out of Five Rule means is that timing is critical!
Primary Residence First, then Rental Property:
Let's take for example that you live in your home for two or more years. You then move out and turn your former home into a rental property.
- If you sell the property within three years after the conversion from personal to rental, you keep your primary exclusion amount. You can have a non-taxable gain during the time it was a rental income-producing property.
- If you sell the property even one day past the three years, you lose your exclusion and all of the gain becomes taxable income.
Rental Property First, then Primary Residence:
In the first example, you used the home as your primary residence and then converted it to a rental. If you sell the home within the three-year period, you get to use your exclusion toward all appreciation in vlaue. For this example, you purchase a rental property that you rent for a period of time. You then move into the property as your primary residence. When you sell your home, any increase in value while it was a rental property is taxed as a capital gain.
How does this work?
Larry and Jane bought their home in 2005 for $200,000. They lived there until March 2010 when they purchased another home, moved out, and began renting the former home. The home was worth $300,000 when they moved out. They collected rental income until February 2013 when they sold the house for $700,000. Larry and Jane have no taxable gain from the appreciation of their former home. The gain of $500,000 ($700,000 selling price - $200,000 original cost ) is excluded from their taxable income.
Larry and Jane waited and sold their former home in April 2013. They now have NOT lived in the home as their primary residence in two out of the five past years. The entire $500,000 is taxable gain.
Now, let's use the same example, but Larry and Jane purchased the home as rental property in 2005 for $200,000. They rented the home until March 2010 when they moved into the home as their primary residence. The home is now worth $300,000. It does not matter when they sell this house, the $100,000 ($300,000 value when converted to primary residence - $200,000 original cost) in appreciation that occurred when it was rental property will be a taxable gain.
NOTE: These examples are simple and there are many other aspects that contribute to your basis and taxable gains and losses.
Another consideration is if the home value is declining rather than appreciating. There may be a loss on the sale. When you sell your primary home for a loss, the loss is a non-deductible loss. But when you sell rental property, the loss is deductible.
If you're considering a purchase or a sale, give us a call, so we can help you to ensure that timing is on your side.