Capital gains tax on rental home sale after buying new house

[sandeep-sherman]

I have just purchased our second home, and intend to rent out our current primary residence for the next 2 years. Will I pay capital gains tax if i sell the rental after 2 years?

[Hal_Al · Accepted solution]

No. But it has nothing to do with buying a new home. The old rule about about using the money from a home sale to but a new home went out in 1997.

The only requirement now is that you owned and lived in the home for at least 2 of the 5 years prior to sale. So, as long as you sell the house within 3 years of moving  out, you may exclude the capital gain (up to $250,000; $500,000 married). This assumes you bought and moved in more than 5 years prior.

But you may not exclude the depreciation recapture from it being a rental. That will be taxed at ordinary income (not capital gain) tax rates. Depreciation recapture is required whether you actually claim depreciation, or not,while it was rented.

[sandeep-sherman]

Could you please explain what depreciation recapture is?

[Hal_Al]

See: <a rel="nofollow" target="_blank" href="http://www.investopedia.com/terms/d/depreciationrecapture.asp">http://www.investopedia.com/terms/d/d...>

It may be best explained by example.

You bought  a house for $100,000. You  rented it out for 2 years, reporting the rental activity (Schedule E) on your tax return.  You claimed $6000 of depreciation (deduction), on your taxes, while you rented it out.

You then  sold the house for $125,000.  Your cost basis is no longer $100,000. It's 100,000 minus 6000 = $94,000. You do not have a $25,000 capital gain. You have a $31,000 gain broken into two pieces; $25,000 long term capital gain and $6000 depreciation recapture. They are taxed at different tax rates.

Depreciation explained: <a rel="nofollow" target="_blank" href="http://www.investopedia.com/terms/d/depreciation.asp">http://www.investopedia.com/terms/d/depreciati...>

[sandeep-sherman]

Thank you! So as long as the depreciation recapture and the long term capital gains are within 250000/500000 I still wouldn't need to pay capital gains taxes, is that right?

[Hal_Al]

No. The depreciation recapture is not eligible for the  250000/500000 exclusion.
Because you got a tax deduction, for depreciation, while you were renting it; you have to "recapture" that deduction when you sell it. using the example, you will pay tax on $6000.  And you will pay that tax at ordinary income tax rates, not capital gains rate. But (again using the example); you will not pay tax on the $25,000 capital gain.

[sandeep-sherman]

Thank you!

[ugopinath]

Would anybody have advice regarding how to convert primary residence into rental without paying capital gains tax? 

Thanks in advance and grateful to any advice

[Carl]

Would anybody have advice regarding how to convert primary residence into rental without paying capital gains tax?

You've already been given that information above. Tax laws states that when you sell a home if it was your *primary* residence for at least 2 of the last 5 years you owned it, then you can exclude from capital gains:

 - The first $250,000 of gain if filing single or MFS.

 - The first $500,000 of gain if filing a joint return and *BOTH* you and your spouse meet the "lived in" requirement.

You must have lived in the home as your primary residence for at least 24 of the last 60 months you owned it. The months lived in do not have to be consecutive either.  Also, don't mistake the requirement by thinking you are required to own it for 5 years. You are not required to own it for 5 years. If you owned it for only 25 months that's fine so long as it was your primary residence for 24 of those 25 months.

To be more precise, if it was your residence for at least 730 days of the last 1826 days you owned it, you qualify for the exclusion.