Peter G. Robbins, CPA, The Daily Record Newswire
Q: A couple years ago my husband and I bought a new home. Because the real estate market was so depressed, we rented our old house. Now we have an offer to sell the house. We are concerned we will have to pay taxes on the sale, and by the time we get done paying off the mortgage and the taxes there may not be much money left for us. If so, we would rather just keep renting the house rather than selling. Any advice?
A: First, I need to address the general rules for selling a personal residence. Generally, an individual can exclude $250,000 ($500,000 for a married couple) of gain on the sale of a home if three tests are met:
The home was owned for at least two years during the five-year period ending on the date of sale.
The home was used as the principal residence for at least two years during the five-year period ending on the date of sale.
Gain from the sale of another home was not excluded during the two-year period ending on the date of sale.
You will need to analyze your specific situation to make sure you meet each of these tests. Note that the two-year period does not need to be continuous, so even if you had moved in and out of the house over the five-year period, you would still qualify for the gain exclusion.
In your case, because you moved out of the house and rented the home for a period of time, your exclusion may be limited. The IRS has ruled that temporary rental of a residence prior to sale does not necessarily mean you will not get the full exclusion. However, if the property is actually converted to rental property, the answer may be different.
The distinction between a temporary rental and a conversion to rental property is based on your intent and profit motive, as well as how the rental and related expenses were reported on prior tax returns. Reporting the rental on Schedule E in your return and deducting expenses such as insurance, maintenance and depreciation tends to indicate the property has been converted to a rental. However, if the rental is reported as other income and only otherwise deductible expenses (mortgage interest and property taxes) are reported, the property has the appearance of being a temporary rental pending sale.
Interestingly, the Ninth Circuit Court, has ruled contrary to the IRS, saying that a residence can be rented temporarily with the intent to make a profit without jeopardizing the sale exclusion. So, the subjective circumstances and intent can be the determining factor. For example, if the home was continuously listed for sale during the period of rental, it would help establish that the rental was temporary.
Even if the home is deemed to have been converted from a personal residence to a rental property, the exclusion may still be available, and the three tests for qualification can still be applied to shelter the gain. Any depreciation allowed or allowable on the property after May 6, 1997, is not eligible for the exclusion and must be reported as taxable income. But the remaining gain may still be excluded.
Gain from the sale that is attributable to a period of “nonqualified use” is not eligible for the exclusion. Generally, “nonqualified use” refers to any business or rental use after 2008 when the property was not used as a principal residence. Since the period in the five-year testing period after the home was last used as a residence and before the time it is sold is excluded from the definition of “nonqualified use,” this limitation normally will apply in situations such as when a vacation home or rental is later converted to a personal residence.
If the gain on sale of the home is completely excluded, it does not need to be reported on your tax return. However, if there is a gain, or if you received a Form 1099-S, you will need to report the sale on your return.
I assume by now you are scratching your head and wondering how a simple thing like selling your home can get so complicated. As Otto von Bismarck said, “Laws are like sausages, it is better not to see them being made.”
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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.
Peter Robbins is a partner in the Boise, Idaho, office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.
