Claiming a Tax Exemption When Selling a Home That is Now a Rental

I’d like to share with you a recent question that I received from a reader of my blog. The question was:

“I lived in my primary home for two years and now it’s a rental, can I sell it without paying capital gains?”

My “short” answer is:

That depends on how long the house has been a rental.

No need to push when  selling your primary residence

By Way of Background Information

The 1997 Taxpayer Relief Act was a great boost for average people who wanted to sell their home and buy a new one. It was also a great boost for investors. Couples are allowed to exclude up to $500,000 of the capital gain on the sale of their primary residence. Single individuals can exclude up to $250,000.

In other words, the sale of the house is never reported on your federal IRS forms if the capital gain is less than the $500,000 and $250,000 limits.

This exclusion is based on compliance with two requirements:

1.)  The home must have been the primary residence for both spouses during two of the last five years. The two years do not have to be consecutive but if you rent out the primary residence for more than three years you would be required to occupy it again for two years.

 2.)  The exclusion is available only once every two years.

What if you sell you house and your capital gains exceed the established limit?

Capital gains above $250,000 for singles and $500,000 for couples are taxed at the applicable rate.

What if you sell your house before meeting the two year requirement?

If you qualify under one of the “unforeseen events” listed in  Internal Revenue Service Publication 523 Selling Your Home, such as a job change, illness or an unusual hardship, you can still qualify for a prorated exclusion.

The Ideal Strategy for the Pathologically Conservative Investor

Typical conservative investor.

Utilization of this tax exemption is the safest investment strategy for the conservative investor who wants to take few risks. This is the type of investor who wears both suspenders and a belt to hold up his pants. They like to play it really safe.

Under this strategy, the investors can qualify for the least expensive type of  loan, the owner-occupied loan. There is no need to worry about tenants destroying your rental property or not paying the rent. You completely control the investment by living in the property yourself. When you sell, you have the opportunity to make up to $500,000 tax-free profit every two years.

So, following that long-winded, yet surprisingly informative, background spiel, my “final” answer to the question is:

If you have lived in your house 2 of the last 5 years, you are entitled to take the exemption.

 

Coming Soon!

How to Turn Your Home into a Rental House, Instead of Selling It

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17 Responses to “Claiming a Tax Exemption When Selling a Home That is Now a Rental”

  1. This is great information Terry. Some of these tax questions can be very confusing, especially for newer investors.

    • Terry says:

      Thanks Sharon.

      After I wrote that article, I thought about that fact that we may not have this great tax exemption forever.

      Regardless of who is elected president this year, I have a feeling that a lot of these tax exemptions are going to be on the chopping block.

  2. Great explanation, Terry. Do you have any experience with 1038 exchanges?

    • Terry says:

      Kim,

      I attended a seminar about them once, but have never done an exchange. It’s actually called a 1031 exchange

      What stands out in my mind about the 1031 exchange is that you have a limited time frame to sell your property and to buy a new “like kind” property. If the owner of the property that you want to purchase decides to pull out of the deal at the last minute, it can leave you in a precarious financial situation.

      There is also a 7% fee you pay to the “qualified intermediary” who facilitates the process.

      Frankly, this exchange process never appealed to me.

  3. Savvy Scot says:

    Very interesting point here. Tax exemption is something that I would never have thought about – I wonder what the rules are in the UK around this…

  4. Jason says:

    Thanks for the clarification! I actually knew this because this past Tuesday/Thursday we did a dinner seminar on “Future Tax Implications: Romney vs Obama”…and this happened to be a subject we discussed as Obama’s official stance is to tax these profits at 25% (it just has never come up because of the housing debacle in 2008 and he’s never had to try pushing it into law since there aren’t a lot of people that are selling homes and making profits).

    Anyway, not trying to get into a political debate here. Our seminar was simply an educational event comparing both sides and what each side proposes and how it will affect seniors. I just wanted to share how I knew the information! I had originally believed that you had to live there for the entire time…it’s good to know that’s not true though!

  5. Terry says:

    Jason,

    Thanks for sharing that background information. It sounds like that was quite an interesting dinner seminar. I wish I could have been there too.

    I’ve still got my fingers crossed that no changes occur to this tax exemption, but as they say at Timex Watches, “only time will tell.”

  6. This is great info! I didn’t know of this exemption. Now, for your next article, can you write how I can start making $100,000 a year to invest in property overnight??

    • Terry says:

      Todd,

      Ha ha. That’s a good suggestion. As usual, you hit the nail right on the head, we have to have some money to get started.

      Many investors use the time tested technique of refinancing one house to purchase another, but that assumes that you have a house to start with.

      That reminds me of a joke about the hazards of unrealistic assumptions that I heard in an economics class:

      “A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, “Let’s smash the can open with a rock.” The chemist says, “Let’s build a fire and heat the can first.” The economist says, “Let’s assume that we have a can-opener…” “

  7. Untemplater says:

    Good stuff to know Terry. Not many people like to think about taxes, but understanding how the various rules work can really make a difference and save a lot of money when filing time comes around.

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  9. Giuliano says:

    Great and informative article Terry.

    Tax exemptions can provide tons of savings. The key is to know what they are! I appreciate that you laid it out in plain English.

  10. Weasel says:

    Wow, this is great! I had no idea that you could claim a tax exemption when you sell a home that you had converted. Do you think it’s a good idea to live in a future rental before renting it?

    • Terry says:

      Weasel,

      Yes, I do think that it’s a good idea to live in a future rental before renting. There are a lot of financial advantages to living in an investment property while you repair it. I am writing a book on that very topic right now, entitled “How to Turn Your Home Into a Rental House.”

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