capital gains - two homes

[astridwilson]

I have a vacation rental home that I want to move into and live for around 10 years, but don’t really want to sell my primary residence, as I may want to return, and my son wants to live in the house during that time.  If in the future I decide to sell both properties to move to a smaller forever home, how can I sell both my vacation rental and my primary residence and avoid capital gains?

[GeorgeDenseff]

You can only have one primary residence at a time.  When you sell, you need to have lived in that residence for at least two of the preceding five years.  You could accomplish that by living in each home as your primary residence for two of the last five years.

[tagteam]

@astridwilson 

You should read through the IRS publication at the link below.

https://www.irs.gov/publications/p523#en_US_2020_publink100073574

Note that you will have to recapture depreciation deductions taken (or which should have been taken) on your rental property if you sell at a gain.

You may be able to defer capital gains (and depreciation recapture) via a like-kind (Section 1031) exchange with respect to your rental property.

See https://www.irs.gov/publications/p544#en_US_2020_publink100072369

[rjs]

Note that you can only claim the exclusion of gain on a primary home once in any two-year period. There is no way to exclude the gain on two homes that you sell at approximately the same time, even if you meet the two-out-of-five-years requirement for both homes. There would have to be at least a 2-year gap between the two sales in order to exclude the gain on both of them. See "Eligibility Step 4—Look-Back" at the first link in tagteam's reply above.

Regarding the possibility of a like-kind exchange, note the following.

• A like-kind exchange defers the gain. It does not eliminate or exclude the gain.
• A like-kind exchange is only for property that you use for investment or business (including using it as a rental). You cannot use the property for personal use, such as using it as your home.
• When you sell a property that you acquired through a like-kind exchange, you cannot exclude the gain if you sell it less than 5 years after the exchange.
• The rules for like-kind exchanges are very complex and the IRS watches them closely. The exchange has to be done through a qualified intermediary, and you need advice from a tax professional who has experience with like-kind exchanges.

[Mike9241]

the taxpayer may not even be eligible to depreciate the property rented to his son. days rented to family members are personal-use days unless fair rental is charged and the unit is the family member's main home.

[tagteam]

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@Mike9241 wrote:

the taxpayer may not even be eligible to depreciate the property rented to his son. days rented to family members are personal-use days unless fair rental is charged and the unit is the family member's main home.

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Actually, days rented to a family member are personal use days even if fair rental is charged unless the family member uses the property as a principal residence (per Section 280A).

The presumption, per the language in the original post, was that @astridwilson had rented the vacation property to unrelated third parties in the past.

[AmeliesUncle]

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@astridwilson wrote:

how can I sell both my vacation rental and my primary residence and avoid capital gains?

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Other than selling them both at a loss, both will be at least partially taxable, based on what you have said.

If the value of the first home has increased considerably, you may reconsider things and sell, even if it was selling it to your son.

[Opus 17]

" If in the future I decide to sell both properties to move to a smaller forever home, how can I sell both my vacation rental and my primary residence and avoid capital gains?"

In this scenario, you can minimize your gains, but not completely avoid them.  Let's consider home A, where you live now.  If you move out for 10 years but continue to own it, you would have to move back and use it as your main home for at least 2 years before you sell it.  In that case, the 10 years that you did not live there would be "non-qualified use."  Unfortunately, this is not explained well in IRS publication 523.  (It's an instruction in table 3 but nowhere else.)

Briefly, let's assume you have owned your main home for 10 years so far.  You move out in 2020, move back in 2030, and sell in 2032.  You have 22 years of total ownership, of which 12 years, or 54%, is qualified (when it was your main home), and 46% is non-qualified.  That means that 46% of the capital gains is taxable.  The qualified gains can be applied agains the exclusion rule (which is $250,000 for single or $500,000 for married filing jointly).  Then, if the qualified gains are more than your exclusion, they are also taxable.

If you rented home A to your son, then you will take depreciation, and that has to be recaptured (taxed) on the  sale.  Depreciation recapture is always taxed first, and you have to recapture depreciation you took or could have taken, so you might as well take it.  (If your son lives there rent free, and you just consider it a second family home, you don't worry about depreciation.). There are other important rules to follow if you plan to rent the home to your son.

Now let's consider the vacation home.  If you live there for 10 years and sell it directly without moving out and creating another vacancy period, you would not have a period of "non-qualified use" to contend with, and all your gain is covered by the $250,000 or $500,000 exclusion rule.  Gain more than your exclusion amount is taxable.

You would have to wait at least 2 years (730 or more days) after selling home B before selling home A in order to use the exclusion on home A. 

[AmeliesUncle]

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@Opus 17 wrote:

Now let's consider the vacation home.  If you live there for 10 years and sell it directly without moving out and creating another vacancy period, you would not have a period of "non-qualified use" to contend with

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There WOULD be "non-qualified use".  It was used as a Principal Residence AFTER it was NOT the Principal Residence.   That triggers the non-residence period to be Nonqualified Use.

[Opus 17]

@AmeliesUncle 

In general, I would have said the same thing, except that after reading the instructions in table 3 of publication 523, this use would not be included as “non-qualified“.  That raises an interesting question — if a taxpayer relies on the instructions in the official IRS publications, and the instructions turned out to be faulty, could they use the instructions as a perfect defense?  Alternatively, our understanding of non-qualified use is incorrect.

Additionally, any period of time before the rules changed in 2008 would not be considered non-qualified use even if your understanding is generally correct, so it also depends on how long the family has owned the vacation home.  

And of course, this entire discussion assumes that the tax laws and the instructions won’t change in the next 12 years, which is a pretty far-reaching assumption.

[tagteam]

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@Opus 17 wrote:

....if a taxpayer relies on the instructions in the official IRS publications, and the instructions turned out to be faulty, could they use the instructions as a perfect defense?  

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This is well settled and has actually occurred in the past where the instructions were in error or otherwise inconsistent with the Code and/or Regs.

The taxpayer could use the publication (or instructions) as authority to avoid any penalties that might be imposed (for understating income tax liability) but not any assessment of tax and interest.

See Treas. Reg. §1.6662-4 re what is considered to be "substantial authority".