Unfortunately, sometimes dreams don’t come true. In my quest to simplify life, I was blinded by the belief that the rental property I bought in 2003 would also be eligible for the full $250,000 / $500,000 tax-free profit exclusion if I moved back in tomorrow and lived in it for the next two years before selling.
I believed this to be true because I sold a rental property in 2017 that was eligible for the full $250,000 / $500,000 tax-free profit exclusion. I only rented out the property for 2.5 years after living in it for 10 years prior.
Taking Advantage Of The Tax-Free Profit Exclusion Rule
With this new rental property I’m considering selling, I lived in the property for two years (2003, 2004), and then have been renting it out for the past 14 years. Even if my family moved back into the rental for two years, we’d only be able to get a prorated tax-free profit exclusion equal to the length of time we lived in the property divided by the entire length of ownership.
That’s normally the case for rental properties bought after January 1, 2009. However, a law was passed since I bought the property where all use of the rental prior to January 1, 2009 is deemed as “qualified use.”
In other words, the prorated amount of our tax-free profit exclusion would equal Qualified Use / Years of Ownership. Numerator = 2003, 2004, 2005, 2006, 2007, 2008 + 2018, 2019 (moving back in for two years) = 8. Denominator = 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 = 17. Prorated amount = 8 / 17 = 47%. If my gain is $720,000, then my tax free gain = 47% X $720,000 = $338,400. With a 27% effective tax rate, my tax savings = $91,368.
Earning tax-free profits of $338,400 is better than a poke in the eye. However, it is certainly not as enticing as earning $500,000 in tax free profits as a married couple. And to clarify, I’m not limited to 47% of the $250,000 / $500,000 number.
I’m limited to 47% of the gain. That gain is then limited to $250,000 / $500,000. In other words, at a 47% prorated amount, I can have a capital gain of $1,063,829 before I run up to the $500,000 limit as a married couple.
Tax-Free Profit Exclusion Examples Of Using IRS Code 121
To make further sense of the tax-free profit exclusion when selling a home, I invited Amy, a law partner and fellow property owner who went through this same exercise to elaborate.
he spoke on this subject before when I first considered selling this rental property several years ago, but I forgot. This is why it’s so important to make sure you write out your thesis and explain it to as many people as possible BEFORE making a large financial move.
Internal Revenue Code § 121(a) (tax-free profit exclusion rule) says: “Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.”
For an owner who buys and moves into the property, lives there for at least two years, and later sells it without ever renting it out, the exclusion is simple. You get all of it. But for owners who have turned their primary residence into a rental for some portion of that time, the nuances of § 121 become important.
Examples illustrating how the tax-free profit exclusion works:
Background facts: Bob buys a place on January 1, 2003 for $500k. It’s now 2018, and he is planning to sell it for $900k. He’s trying to figure out how much capital gain he will have. He also wonders whether he should move back into the property for tax savings.
When Bob bought his house in 2003, he moved in right away. He lived there until January 1, 2016, and started renting it out after that. He plans to keep it rented until he sells it. So long as he sells it before January 1, 2019, all of his use is “qualified use” under § 121. The last three years of rental property usage is included in “qualified use” under § 121(b)(5)(C)(ii). That means all of his capital gain is potentially eligible for the exclusion.
His total gain is $400,000, but it’s subject to the $250k/$500k caps in § 121. If he’s single, he can take the $250k exclusion, and he pays capital gains tax on the other $150k. If he’s married, he can take the full $400k exclusion so long as he OR his spouse meet the ownership requirements and so long as both he AND his spouse meet the use requirements for the property.
To the extent that Bob ever took depreciation deductions on the property, either for “home office” or other business use while he lived there, or depreciation he took for having the property as a rental, that amount of capital gain must be recognized and taxed (“recaptured”) under § 1250, irrespective of the capital gains exclusion we’re discussing here.
We could spend a whole day going on about that code section, so for now, we’re going to set that issue aside. Just keep in mind that with each of these scenarios, you first pay capital gains on the depreciation recapture, and then you run the math on the exclusions applicable under § 121.
Scenario 2 (A tricky one):
Bob bought his house in 2003 and moved in right away. He lived there until January 1, 2016, and started renting it out after that. But it’s mid-2018, and he’s worried he might not be able to sell it before January 1, 2019. So, to make sure he doesn’t fall short of the 2-out-of-5-years rule, he kicks his tenant out and moves back into the property on July 1, 2018.
Well, Bob just shot himself in the foot. The exception for the 3 years of rental property usage only applies if it’s after the last date that Bob used the property as his primary residence. By moving back in, he turned that 2.5 years of rental property use into “nonqualified use.”
Now he has to prorate his gain. Assume he sold on December 31, 2018. His “qualified use” ran from January 1, 2003 through January 1, 2016 (13 years), plus July 1, 2018 through December 31, 2018 (half a year), and his “unqualified use” was 2.5 years. So 13.5/16 years are “qualified,” and about 84% of his gain is potentially excluded. $400,000 capital gain x 84% = $336,000. The remaining $64,000 of his gain is subject to tax.
There’s More To Calculate
But we’re not done yet. Of that $336,000 potentially excluded capital gain, Bob can take only $250k of it if he is single. If he is married (and if both Bob and his spouse meet the use test), he and his spouse could take the full $336k exclusion.
If Bob continues to live in his old rental, then his prorated capital gains inclusion will continue to grow, but never back to 100%. For example, if he lived in the property until Jan 1, 2022 (for three more years) after moving in on July 1, 2018, his exclusion would be 16.5 / 19 years, or 87%.
The best thing Bob should have done was kick out his tenants with enough time to sell before Jan 1, 2019 to get the full exclusion and not move in before then.
Scenario 3 (the tax law changed on Jan 1, 2009):
Now let’s assume that Bob rented out the property early on and moved in later. Bob bought his house in 2003 and rented it out immediately. Starting on January 1, 2009, the tenants moved out and he moved into the property. He’s now considering selling the property today.
All of Bob’s $400k capital gain is potentially excluded. All rental property activity prior to January 1, 2009 is considered “qualified use.” This new proration portion of § 121 kicked in on January 1, 2009, so all rental usage before then is a freebie, so long as you meet the 2-out-of-5 rule before you sell. If Bob is single, he can take a $250k exclusion. If he is married (and if both Bob and his spouse meet the use test), he and his spouse could take the full $400k exclusion.
Example 4 (another tricky one):
Similar to Example 3, but Bob moves into the property even later. Bob bought his house in 2003 and rented it out immediately. Starting on January 1, 2014, the tenants moved out and he moved into the property.
Now we’re back into proration territory again. Bob’s qualified use consists of the 6 years he owned and rented it from January 1, 2003 until December 31, 2008. Plus the 5 years he lived in it from January 1, 2014 until December 31, 2018. The rental period from January 1, 2009 through December 31, 2013 (5 years) is unqualified use.
So 11/16 years are qualified use, and about 69% of the gain is potentially excluded. $400,000 capital gain x 69% = $276,000. Of that $276,000 potentially excluded capital gain, Bob can take only $250k of it if he is single. If he is married (and if both Bob and his spouse meet the use test), he and his spouse could take the full $276k exclusion, and the remainder would be subject to capital gains tax.
You can see more details from IRS’s website.
Go Through The Numbers Carefully
I’m sure a number of you are still confused after these examples. Just read each scenario multiple times and ask for clarification and you’ll eventually get it. The tax-free profit exclusion can be confusing.
The bottom line: in order to qualify for the full home sale exclusion under the Code Sec. 121(a) two-out-of-five year ownership and Use Rule, the non-qualifying use (rental property, office, etc) after the owner leaves his principal residence can’t exceed three years.
After three years, you must prorate the exclusion by taking the number of qualified years divided by the total years of ownership if you have lived in the property for two out of the last five years. If you don’t meet the 2/5 rule, you get no exclusion at all. Not even proration.
For those of you who’ve owned rental property for a long time (i.e. 10+ years) and are sitting on large gains, it doesn’t seem worthwhile moving back into a rental to try and save on taxes. Instead, the best move is to hold onto your rental property for as long as possible. You want to avoid any selling costs and capital gains tax. Or, you can do a 1031 Exchange and buy a new rental property with the proceeds.
After going through this exercise, my family is probably not going to downgrade our lifestyle by moving back into our two bedroom rental. We could save maybe up to
$43,200 $91,368 in capital gains tax as a married couple. But it’s not worth it. We still get to add in capital improvements to increase our cost basis and lower our tax bill. We want to live life to the fullest now.
The Future Looks Bright
Sometime in the future, we may put the condo on the market once our tenant’s lease runs out. Then we will do a 1031 Exchange into a more expensive property in Honolulu.
We’ll rent out the Honolulu property for at least one year to legitimize the property as a in-kind rental. Then in 1-4 years we’ll move into the property and make it a primary residence. This will be just in time for our son to go to pre-school or kindergarten.
Or, we’ll just keep both properties. Then we will hire a property manager. Afterward, we will save diligently to buy a Hawaii property when it’s time to move. I’ve always felt the best to buy property to enjoy rather than to rent out. There is an issue with keeping both SF properties. I’ll need to find some way to save $1 million more since I won’t have the proceeds from the 1031 Exchange.
Guess I can’t slack too much with Financial Samurai!
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