Converting Rental Property to Principal Residence
Question: In a recent article you said that IRS income tax law was changed to limit the tax benefits when the owner of a rental home moves into that rental home–which then becomes the owner’s “principal residence.” My husband and I are considering converting rental property to our personal residence. We have owned a rental home in Paradise Valley, Arizona for eight years. The appreciation on that home is approximately $500,000. We are planning on retiring to Utah, but don’t want to pay tax on this $500,000 in appreciation. We are willing to move into this rental home as our primary residence for two years, and then sell the home. In light of this change in the tax law, would we have any tax benefit?
Answer: Prior to 2008 an owner of a rental home could move into that rental home as a principal residence for two years, and, upon the sale of the home after two years of residence, the entire capital gain on the sale for up to $500,000 for a married couple ($250,000 for a single person) would be exempt from income tax. This tax windfall was very common in the “boom” mid-2000’s when home values were skyrocketing, and investors owned several rental homes. Investors would move into rental properties every two years and realize the maximum tax benefit on many properties.
In 2008 this tax law changed. An owner is still required to live in the property for two or more years within the past five years to qualify for capital gain income tax benefits, however, no longer is the entire capital gain exempt from income tax. The new law requires a prorated calculation of the tax benefits based on the number of years owned as a rental home and the number of years owned as a principal residence. Therefore, if your Paradise Valley home has been rented for eight years, and then becomes your principal residence for two years, only the time that the Paradise Valley home was your principal residence would be eligible for the capital gain exemption. In other words, if you owned the Paradise Valley home for ten years—eight years as a rental home and two years as a principal residence—only 2/10 of the $500,000 capital gain would be exempt from income tax. That amount would be $100,000.
How does the IRS define principal residence?
A principal residence is the primary home which a person or persons inhabit. The term “principal residence” is sometimes substituted with terms “primary residence” or “personal residence,” as they all mean basically the same thing–the main home in which you live. The type of home is inconsequential as the property you own can be a single-family home, condominium, cooperative apartment, mobile home, or houseboat as long as the principal residence is where you live most of the time.
If you own or live in more than one home, the test for determining which home is your main home is an IRS “facts and circumstances” analysis. The most important factor for the IRS analysis is determining at which property you spend the most time. “Facts,” such as if the address is listed on your U.S. Postal Service address, Voter Registration Card, federal and state tax returns, driver’s license, or car registration, “and circumstances,” such as the proximity of the property to your personal landmarks like workplace, financial institution, the residence of one or more family members, health club, or religious organization, are also considered for the IRS analysis.
Uninterrupted residence is not a requirement.
Qualification for the tax exclusion hinges on the essential question of whether you live in the property for at least two of the past five years. Uninterrupted residence is not necessary to qualify for the principal residence requirement. Eligibility is simply calculated by totaling the amount of time spent living at the home in the past five years, and whether the combined time totals twenty-four months (or 730 days).
“Vacation or other short absence” vs. “a sabbatical”
Although uninterrupted residence is not necessary to qualify, absences due to vacations or business trips can further complicate an eligibility calculation. The IRS does not define a set length of time wherein an absence from the home is no longer counted as time lived at home. Examples posted on the irs.gov website only help to set a range of time. “[A] vacation or other short absence” from the home of two weeks does count as time you lived at home, but a one year “sabbatical” does not. Any absence from the home between two weeks and one year is likely questioned by the IRS in a similar manner to the IRS “facts and circumstances” analysis above.
Note: A short term lease of a property through the use of an online home sharing service (such as Airbnb or VRBO) while the owner-occupier is on “a vacation or other short absence” would not be added to any rental period calculation against an owner seeking the two-year tax exemption.
You should not make any decision about the tax treatment of appreciation on the sale of property without talking to a CPA or other tax professional. Contact Combs Law Group, P.C. if you would like more information regarding tax law and real property.