Converting a Rental to a Residence: “Many Taxpayers Can Take Advantage of Two Tax Code Sections”

Some taxpayers may be able to take advantage of two tax code sections by first performing an IRC §1031 tax deferred exchange and later converting the replacement property into a principle residence which may qualify for tax benefits under IRC §121.

 

COVERTING A RENTAL – SUMMARY OF IRC SECTION 121

Section 121 of the Internal Revenue Code allows:

  • Exclusion up to $250,000 of the capital gain on a principal residence for a single taxpayer and $500,000 for a married couple filing jointly.
  • To qualify, the taxpayer must own and use the home as a principal residence for two of the five years prior to the sale. The ownership and use periods do not need to be concurrent.

HOW LONG SHOULD THE HOUSE BE RENTED BEFORE CONVERTING A RENTAL?

Section 1031 of the tax code does not provide a defined “holding period” for investment properties. IRC §1031 does specify that a taxpayer must have an “intent” to hold the property for either investment or business purposes to be considered a qualifying “like-kind” property.

The time period the property is held is only one factor the IRS may look at to determine the taxpayer’s intent. The IRS can examine all the other facts and circumstances that may or may not support the intent to hold for investment. Creating a paper trail establishing the original intent to hold for investment, along with the reasons why the replacement property was later converted to a principal residence, would be beneficial to the taxpayer in the event of an audit.

 

TWO PERSPECTIVES ON A “HOLDING PERIOD” BEFORE CONVERTING A RENTAL

Some legal and tax advisors recommend that a taxpayer hold a § 1031 exchange property for a minimum of at least twelve months. The reason for this is that a holding period of 12 or more months results in the taxpayer reflecting the property as an investment property in two tax filing years.

Another perspective is holding the § 1031 exchange property for at least two years. In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of two years was sufficient. Although a private letter ruling does not establish legal precedent for every taxpayer, there are many legal and tax advisors who believe two years is a conservative holding period, provided no other significant factors contradict the investment intent.

 

COST RECOVERY/DEPRECIATION

Capital gain taxes must be paid on the cost recovery (“depreciation”) taken after May 6, 1997 (at 2.5%), but may exclude additional gain on the principal residence, up to the maximum amounts allowed by §121.