Tax considerations when converting an investment property to a primary residence - by William Lopriore

November 02, 2018 - Front Section
William Lopriore

Since January 1, 2009, federal tax law limits the amount of gain eligible for exclusion from taxation (known as the “Primary Residence Exclusion”) when you sell a house used as a primary residence, if you also used the house for another purpose, such as a rental.

Under Section 121 of the Internal Revenue Code, you will not owe capital gain taxes on up to $250,000 of gain, or $500,000 of gain if married and filing jointly, when you sell a house used as a primary residence for any two of the previous five years. 

The gain eligible for Primary Residence Exclusion from taxation will be reduced according to the ratio of the number of years the property is used for non-primary residence purposes to the total number of years owned. Periods of use other than as a primary residence occurring prior to January 1, 2009 will not reduce the excludable gain. 

Property acquired in a 1031 exchange and then converted to your primary residence must be owned at least five years before being eligible for the 121 exclusion.  However, if the property was first used as a primary residence and then converted to investment property, gain may be excluded under Section 121, and then taxes can be deferred under Section 1031 on the remaining gain.

Nothing contained in this article is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and informational purposes only. The views and opinions expressed in this article are solely those of this author, and do not necessarily reflect the views, opinions, or policies of this author’s employer, First American Exchange Company, LLC.

William Lopriore is the northeast regional manager and counsel for First American Exchange Company, LLC, Wayland, Mass

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Michael Lantrip, Author of "How To Do A Section 1031 Like Kind Exchange." 11/2/18 3:02 PM

The property does not have to be owned for five years in order to qualify for Section 121. The property can be converted to your primary residence and used as your primary residence for two years, and at that point you qualify for Section 121. However, your Section 121 exclusion amount only covers the two years for which the property was your primary residence. If, for example, you used it as a rental property for two years prior to converting it to you primary residence, than half of the Capital Gains can be excluded from taxation under Section 121. Also, you must pay the Depreciation Recapture tax on the depreciation claimed during the two years that the property was used as rental property, in addition to the Capital Gains tax on the same two years. Michael Lantrip, Attorney | Accountant | Investor

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