Understanding the Tax Implications of Converting Your Primary Residence to a Rental Property

A client recently asked an important question that many homeowners face:

If the house purchase I'm hoping to make goes through and my current residence becomes a rental property, does that change what happens if I sell it in the future or if I want to move back in at a later date? I assume that selling it after I've been renting versus selling it as my primary residence changes the taxes-is that correct? And if it becomes an income-producing property but I move back in does it turn back into a primary residence?"

This question touches on several key aspects of U.S. tax law. Converting your current home into a rental property and then deciding to sell it or move back in later can significantly impact your tax situation. Here's what you need to know:

1. Selling the Property After Renting It Out
   • Primary Residence Exclusion: When you sell your primary residence, you can exclude up to $250,000 of capital gains from your taxable income if you're single, or $500,000 if you're married filing jointly. However, to qualify for this exclusion, you must have owned and lived in the home as your primary residence for at least two of the five years preceding the sale.
   •  Rental Property Status: Once you rent out your home, it becomes an income-producing property. The "2 out of 5 years" rule still applies from the last time you lived there as your primary residence. If the property is rented out for more than three years without you living there, you may lose the ability to exclude capital gains under the primary residence exclusion
   • Depreciation Recapture: While renting out the property, you must depreciate the building's value over time. If you later sell the property, the IRS requires you to "recapture" this depreciation, meaning you'll need to pay taxes on the depreciation taken at a rate of up to 25%, regardless of whether you qualify for the primary residence exclusion.
2. Moving Back into the Rental Property
   • Converting Back to a Primary Residence: If you move back into the property and live there for at least two out of the five years before selling it, the property may again qualify as your primary residence, allowing you to take advantage of the primary residence exclusion on any capital gains.
   • Mixed-Use Consideration: If the property has been both a rental and your primary residence, the IRS may consider it a "mixed-use property." In this case, you could exclude some of the gain under the primary residence exclusion, but any depreciation taken during the rental period will still be subject to recapture.

Key Considerations

1. Duration of Rental: The length of time the property is rented out can impact your ability to exclude gains from taxation.
2. Depreciation Recapture: Any depreciation taken while the property was a rental must be recaptured and taxed upon sale, even if you move back in and re-establish it as your primary residence.
3. Planning Ahead: If you're thinking about converting your residence into a rental and possibly selling it later, careful planning is essential to minimize potential tax liabilities.

For personalized advice and to explore the best strategies for your specific situation, consult with a CPA who can help you navigate these complexities and optimize your tax outcomes. Cambaliza McGee LLP team specializes in business and personal tax planning. We are more than number crunchers.