Owe capital gain tax on primary residence that was converted into a rental property?

Dear Tax Talk,
I bought a property in 2009 at $235,000 and made improvements worth $50,000. It was our primary residence from July 2009 until April 2015. As of May 2015, it became a rental property. Now we are thinking of putting the rental property on the market for about $450,000 and hoping it will sell in the next 5-6 months. I know I am looking at capital gains on the profit ($165,000). But based on IRS documentation, since it was our primary residence for at least 2 years in the last 5 years from the date of selling, I qualify for excluding this capital gain (i.e., I am not expected to pay any capital gains).

Is my conclusion right? Or am I still liable to some percentage of capital gains given that it has been a rental property for over a year now? If it helps, my spouse and I file tax returns jointly, and we are based in Texas. Thanking you in advance.
— Bosco

© Iakov Filimonov/Shutterstock.com

Dear Bosco,
Because your home was converted to a rental property, you may have to report a portion of the gain as income on your tax return as a result of the sale.

You are correct that you will meet the IRS rule for excluding some of the gain on the sale of the property, as you owned the home and it was used as your main home for 2 of the last 5 years. However, because it was used a portion of the time as a rental property, additional rules come into play now.

When you converted your home to rental property, along with your other rental expenses of property taxes, mortgage interest, insurance, etc., you were also allowed to claim a depreciation deduction which lets you deduct the cost of the property over time. When the property is sold, you may have to “recapture” a portion or all of the depreciation at ordinary income tax rates on your tax return. The balance of the taxable gain on the sale that is not taxed at ordinary income tax rates is taxed more favorably as a capital gain.

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3 steps to follow

So how do you figure all this out? Well, it takes several calculations and a lot of patience on your part:

1. Figure out your overall gain on the sale of the property.
2. Figure out the “taxable” gain on the sale of the property. This is where the allocation between personal home use and rental use takes place.
3. Figure out what portion of the gain is taxable as ordinary income and what is taxable as capital-gain income.

IRS Publication 523, Selling Your Home, has worksheets for all 3 steps listed above so it should be added to your reading list — and make that sooner rather than later.

Take advantage of suspended losses

Also, did you own rental property in the past in which you suffered losses? If so, it is important to note that if the passive-investment activity rules for the rental property resulted in “suspended losses” in prior years, you can use them on your tax return. Those suspended losses would have been tracked on Form 8582, Passive Activity Loss Limitations.

You may want to consider having a qualified tax professional assist you on the income tax reporting for the sale of the property as it does get quite a bit complicated and the worksheets are not for the faint of heart.

Thanks for the great question and all the best to you!

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