Tax implications - Converting a rental house into a primary residence.

You still get the section 121 exclusion, but it is reduced. Section

121 allows 250k of capital gain to be tax free if single, and 500k if married provided you lived in the home for the last 2 years, or 2 of the last 5 years.

You have to allocate the capital gain between the rental use and personal use. Only the capital gain due to personal use is tax-free (unless it is more than 500k).

Say you bought the house for $100,000. 10 years depreciation would be about $36,300. You sell it in 2012 for $1,000,000. So 2 years qualified use, 10 non-qualifed. So of the 900k capital gain, 2/12 or $150,000 is qualified. 750,000 is not qualified. You have to recapture your depreciation, so at the end must pay capital gain on $786,300. At least that's how I think the example is.

See IRS Publication 523.

Assuming that both spouses used the home as their primary residence for those 2 years and file a joint return for the year of sale the full $500,000 exclusion is available. However, not all the gain is excludable. Depreciation allowed or allowable during the rental period is recaptured and taxed as ordinary income with a maximum rate of 25%. Of the remaining gain, the percentage attributable to 2009 cannot be excluded because of "nonqualified use" and is taxed as a long-term cap gain. The remaining gain is excludable up to $500,000.

This situation is covered in detail in Comprehensive Example 3 on page

25 of Pub 523.

Phil Marti VITA/TCE Volunteer Clarksburg, MD

First, there is a period of "nonqualified" use, specifically the year

2009.

------------------------------------- MOMAN at Large//.

Thanks for input Phil. Now have another question, after I explained this to owner, the owner asked me if there was anyway left for him to legally do something like a 1031 exchange with his property or if I knew of any other legal tax loophole way for him to be able to avoid paying any capital gains tax when he sells his new home/residence in the future? He thought it would be excluded from any capital gains taxes due to the $250K and $500K exclusion on paying capital gains taxes on your home you live in for 2 out of 5 yr.

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Currently, he cannot 1031 exchange the property because it is not business use property. He would need to convert it back to a rental first. Even so, he still cannot avoid paying tax on the amount of depreciation taken. However, if he has any carried passive losses accumulated, he may be able to offset the income.

The only way for him to get out of this without paying income tax is to die. If the value of this entire net estate is less than the estate tax unified credit, then he escapes tax free.

This is not very nice advice.

Maybe unpleasant to contemplate, but very good advice that I've given on a number of occasions to DIY estate planners who are about to mess things up by putting someone on the title to the house.

Phil Marti VITA/TCE Volunteer Clarksburg, MD

removeps - the advice was not a suggestion for the OP to die, just a fact of how the current tax laws work.

When discussing tax matters and estate planning, there's too much that can go wrong, and we need to get as comfortable discussing the issues surrounding death as we are all the other PG14 topics that are in our face every day.

To Phil - my mother's lawyers made just the mess you allude to, and the result will be (in today's dollars and tax code) a $30,000 tax bill that could have easily been zero with the proper council. Strike that, zero with no council at all, it was talking to the lawyer (obviously one not trained in estate planning) that started the bad retitling.

He wanted a way out. That is the way out that the IRC provides for. Death is the only way to wipe out depreciation taken, short of an act of Congress. It may not be nice, but it satifies the question.

------------------------------------- MOMAN at Large//.

Thanks for input, well taken, no feelings hurt here, I appreciate the candor. It is what it is! I told owner no way out of paying tax on recapture depreciation anymore he would have to pay tax on that amount under new rules.

BUT then he came back with One more question I was asked and would like you guys to give me some input on.

What if owner(man) assigns or signs over the title to the previous rental house now converted primary residence to his wife and after 2 years the wife sells the house that is in her name only?

I was stumped on this. Would he be able to do that, I mean would his wife have to pay some sort of tax even if the husband says here, I am signing over ownership of this house to you wife in your name. The wife is not on the current title to the home they are living in now(which was previously a rental of the owner)?

Please anyone that has had experience in this area or input is welcome. And thanks for serious input. Very helpful.

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I'm not. When such things are actually possible they are quickly discovered and corrected. "I can avoid Wash Sale rules, by buying back in my wife's account" and such spousal things are self-dealing, and not allowed. If he simply transferred title, she'd take on the same history he had, just like when I gift my daughter stock, she takes on my basis. Joe

Thanks for input, well taken, no feelings hurt here, I appreciate the

Depreciation still recaptured. Related party transfer disregarded.

------------------------------------- MOMAN at Large//.

So when you say "disregarded on transfer", what do you mean exactly? Would the wife now pay tax on recaptured depreciation but not on the rest of the gain from the sale of rental/now residence once she becomes sole owner and has her 121 gain exclusion? Sorry for being rock head here, just confusing me and hard to get handle on today. Thanks for input and answers.

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