No Tax on Sale of Principal Residence
Question: We have lived in our Phoenix home for almost 20 years. For many years we rented a home that we own in Surprise to a nice elderly couple. The husband has now died and the wife is moving in with one of her children. We want to sell this Surprise home rather than find a new tenant because we do not want to be property managers! If we sell this Surprise home, however, our accountant says that, because of appreciation in the value of the home and the recapture of depreciation deductions, we will have to pay a significant amount of taxes. In order to not pay these taxes, our accountant suggests that we sell our Phoenix home and then move into our Surprise home. He says that we would not have to pay taxes on the sale of our Phoenix home because our Phoenix home has been our principal residence for more than two years. Our accountant also says that, because our Surprise home will now be our principal residence, we would not have to pay any taxes if we sell the Surprise home after living there at least 2 years. Although we are not anxious to move back into the Surprise home for even 2 years, we like the idea of not having to pay any taxes on the sale of our Phoenix home now, and not having to pay any taxes when we sell our Surprise home after living there two years. Is our accountant right?
Answer: Your accountant is correct that you can sell your Phoenix home now and, assuming that as a married couple you do not have a gain of more than $500,000, you will pay no income tax on the sale of your Phoenix home. The reason is that there is a $500,000 tax exemption for a married couple ($250,000 for a single person) upon the sale of a principal residence, if the principal residence has been lived in for two of the preceding five years.
If you then move from your Phoenix home to the Surprise home and sell the Surprise home after two years, you should have reduced tax liability on the sale of your Surprise home. The amount of this reduced tax liability will depend on several factors which should be discussed with your accountant. The major factor is that since 2008 the $500,000 tax exemption must be prorated based on the number of years that the home was owned as a rental home and the number of years that the home was used as a principal residence. I.R.C. Section 121 (b)(4). For example, if after renting the Surprise home for the last three years, you live in the Surprise home for two years, and then sell the home for a gain of $500,000, only $200,000 (2/5th) of the $500,000 gain would be exempt from tax. The remaining $300,000 (3/5th) of the $500000 gain would be subject to tax. Finally, there will also be recapture of the depreciation taken during the time that the Surprise home was a rental home.
Note: If any rental home was rented in 2008 or prior years and then converted to a primary residence for two years or more and sold, special rules apply for the $500,000 tax exemption.