If a person changes their property from "partial" rental to full home for 3 years and sells what are the tax implications?

[CaddyGrn]

Potential scenario:

Lived in a large home that had 3 units.  Lived in one unit that was 1/2 of the building.  Depreciated the rental portion of the home (1/2 of the building) for 20 years, so there are 7 years left that we can still depreciate as I understand.  If one turns the property into a single home (which can be done easily) for 3 years and sells the property, do you pay capital gains from the rental portion, or just as you might from the sale of your own home?

[MissMCJ]

When you sell the home, the depreciation is "paid back" by subtracting it from the basis of the home.  Then you calculate your profit and pay capital gains on the amount over $250,000 for a single taxpayer or $500,000 for a taxpayer and spouse filing jointly.  

[Hal_Al]

In addition to the depreciation recapture, you must prorate the rest of the capital gain between rental time (and space) and home use. 

Only  rental time ("non qualified use") after 2008 is included in the calculation. 

Deprecation since May 6, 1997 must still be recaptured, even in a  home sale exclusion situation.

[CaddyGrn]

If I understand correctly, we would take the "basis" of the portion of the home we depreciated, (say it was $200,000 for the apts.) and deduct the total amount depreciated over the 20+ years (say $50,000) and anything over $500,000 would be considered capital gains?  So in this scenario, we wouldn't have any capital gains specifically....?

Thank you very much for responding.

[Hal_Al]

No.

Using an example: Cost basis in entire property was $400,000 ($200,000 [50%] allocated to rental based on square footage).  Upon conversion in, 2020, you had accumulated $50,000 in depreciation.  Let's ignore any cost to covert to single family.*  You sell for $700,000 in 2023. You have a $300, 000 long term capital gain (LTCG)  PLUS $50,000 depreciation recapture.  $150,000 of the LTCG is allocated to the rental half (50%). That $150,000 is further allocated between rental and residence, base on time. 12 years (2008-2020) rental and 3  (2021-2023) years residence.  12/15 = 80%. You have a $120,000 (0.80 x 150,000) taxable LTCG plus  a $50,000 taxable section 1250 (depreciation recapture)  gain.  Net $170,000 taxable gain and $180,000 (150,000 + 30,000) excludable home sale gain  (excludable since $180,000 is less than $500,000).  Note that none of the gain attributable to rental time is excludable under the $500,000 exclusion limit.  Converting it to your home only gets you out of paying tax on a small portion of the gain.

Depending on how much total income you have LTCG are partially taxed at 0%, 15%, 20% and/or 23.8%. Depreciation recapture is taxed at your marginal rate, but not more than 25%.  TurboTax is capable of handling this complex calculation.  But, you have to carefully enter the info.  When the time comes, you should consider having your tax return done professionally. 

* I'm not sure how the conversion cost should be handled.  Since the cost was incurred after it was a rental, I think it would be allocated all to residence as long as the two year rule was met.  If the two year rule isn't met, Conversion cost might have to be  allocated to both the residence and rental shares.