Proper conversion of rental property to personal property can eliminate a portion of the capital gains tax.
Job transfers and losses are just a couple of the reasons that people convert the primary residence to rental property. Over time, if the situation that caused the property rental changes, the owners may wish to move back into the rental home and reclaim it as the primary residence. While you are welcome to move back into your property at any time the home is unencumbered by an executed lease, you should be aware of the tax implications of the sale of the home at a future date. Proper planning can help you reduce or even eliminate capital gain taxes from the sale of a previous rental property.
Instructions
Convert Property to Personal Use
1. Move into your property that was previously rented and change all your personal information, such as driver's license, insurance and mail, to reflect the address of the property.
2. File with the county/parish for homestead exemption, if it is offered in your area. Homestead exemption is a legal transaction that verifies you are using the home as your primary residence.
3. Remain in the home for a minimum of two years of the five years preceding a sale of the home. For example, if you rented the property from January 2001 to December 2007 and moved back in the home January 2008, you must remain in the home until January 2010 in order to avoid capital gain taxes on the entire profit from the sale of the home. The Internal Revenue Service (IRS) considers a property personal use if it is occupied by the owner a minimum of two years of the five years prior to a sale. If the property was properly converted to personal use by the two-year residence rule, you can exclude a portion of the first $250k ($500k if filing jointly) of profit from the sale from capital gains tax.
Calculate Profit on Sale
4. Determine your basis in the property. Your basis in the property is your cost of the property plus closing costs on the loan plus any improvements made to the property that have a useful life of more than one year, such as roof or air conditioning replacement. Basic repairs are not considered improvements to the property.
5. Reduce your basis in the property by all depreciation claimed on your tax return while the property was rented. Other reductions to basis include items such as casualty losses previously taken as a tax deduction and certain residential energy credits. Refer to IRS publications for exact rules for calculating basis for the year you sell your home.
6. Subtract your adjusted basis calculated in Step 2 from the sales price of the home. This will be your gain. The amount of the gain you can exclude from income will have to be adjusted for the time period you did not use the property as a qualified personal residence and the depreciation previously taken. The calculation is complex, but fully explained in IRS Publication 523.
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