Rental to primary residence for sale

[owlcreekla]

We helped our daughter purchase a 4-bedroom house (parents & daughter on deed) which she then rented with three other people to cover the mortage and house expenses. She now wants to downsize, so the roommates moved out 12/31/23, turning the rental home into a primary residence for her and her sister. It is currently on the market and once sold, she will purchase a 2-bedroom condo with proceeds from the sale.

How do we best handle the sale? What documentation is required for our 2024 taxes? Do we need to pay capital gains if putting all proceeds into the next residence? If so, is that at time of sale or when file 2024 taxes?  Thank you.

[dsoile · Accepted solution]

Hello owlcreekla

Thank you for your patience, and I hope this event has been helpful. Based on the information you have presented, lets assume the following:

a) your daughter, yourself, and spouse are owners of the home (thus 3 people on the deed)

b) prpoerty started off as rental property and later became personal residence, 

c) decision to downsize, and now daughter and sister live in personal residence until house is sold, so they can purchase new home

Because the home started off as a rental property and then became personal residence, assuming that in previous tax years, when doing taxes, rental income and rental expenses, were factored in, there will be depreciation recapture (this is assuming that depreciation expense on the property and other assets associated with the property were taken). Depreciation recapture is basically paying back the depreciation expense you took advantage of as a deduction in previous tax years.

When the primary residence is sold, the gain on the sale of the home will be made up of two components: 1) a portion of that gain will be taxed as ordinary income up to the maximum tax rate of 25%, which will represent the depreciation recapture and 2) the other portion is taxed at capital gain rate (specifically Long-term capital gains rate, based on the information present)

Assuming the sale occurs in 2024, you will need the following documents: 1) 1099-S, which will detail items associated with the sale, 2) appraisal documents for the home, 3) record of any improvements and additions you made to home prior to sale and costs associated with it, if applicable, 4) record of any selling costs, 5) prior year tax returns, where you included rental activity (income and expenses)

Since all the proceeds will go into purchasing another property, specifically property for personal use, unfortunately, the sale will not apply for Section 1031 exchange. If the property was still a rental property and proceeds from sale were to be used to purchase another rental property, then yes, Section 1031 will apply.

In your case, you would be subjec to both ordinary income tax on portion of gain from depreciation recapture, if applicable and capital gains stax on remaining portion of the gain from sale. 

The paying of the tax will be when you file your 2024 tax returns. So highly reccomend to set portion of proceeds from sale aside to cover the capital gain and ordinary income tax