Capital Gains Exclusion

[gtrkay]

Hello.

I purchased a home in 2006 for $84,000. In March 2019, I moved in to my partner's home and rented out the property I purchased in 2006. During the 4 years Mar 2019 - May 2023 I rented out the house, I was charging $1200/ month rent. My partner and I got married in May 2023. I sold the house I had been renting out for $220,000 (I still owed approximately $60,000 on the mortgage) and he sold the house he owned and we had been living in because we were moving from Texas to Minnesota for new jobs. In the 15 years I owned the home, I spent approximately $25,000 - $30,000 (new kitchen, refinished floors, new windows, new hvac) in capital improvements and an additional $20,000 preparing it for rental, preparing it for sale, and upkeep (painting the exterior and fixing, a break in the sewer line that ran from the house to the main sewer line), and I paid approximately $15,000 in realtor fees, closing costs, etc.. I subsequently purchased a new home in Minnesota in June 2023.

1. Is it accurate that I will be able have a prorated capital gains exclusion of 50% because I lived in the house 1 year out of the 5 before selling and I sold because I was moving out of state for a new job? Does the 12.5 years I lived in the house before turning it into a rental count for nothing when it comes to capital gains taxes?

2. I don't really understand how depreciation, capital improvement expenditures, and expenses impact capital gains taxes. If I made $136,000 on the sale, but spent $25,000 on capital improvements, $20,000 on repairs, and $15,000 when selling, when depreciation is taken into account, what amount am I actually paying capital gains taxes on?

3. The house that was being rented was in my name. The house that my now husband and I lived in was in his name. He made about $100,000 on that sale (capital gains do not apply because it was a primary residence). Our combined income is about $200,000/year before taxes.

[Opus 17]

You can't claim any exclusion on the house you owned prior to the marriage, because you moved out more than 3 years before you sold.  There is no pro-rated exclusion in this case.   You would have had to sell before March 2022 to qualify for the $250,000 exclusion. 

Start by reading publication 523.

https://www.irs.gov/forms-pubs/about-publication-523

Capital gains is the difference between the selling price and your adjusted cost basis. It may not have anything to do with the actual amount of cash you received, if there was a mortgage to pay off.  Your adjusted cost basis is what you originally paid, plus what you spent on permanent improvements (but not repairs, see pub 523) minus the depreciation you took or could have taken when the home was rented.  You can also include certain closing costs in your adjusted cost basis.

I don't think you are clear on the difference between improvements and repairs, and any rental expenses should have been deducted against rental income.   See pub 523 for more on improvements.

You can reduce the selling price by certain costs of sale including real estate commission and advertising.  But you can't include adjustments for cleaning or repairs, those are things all homeowners are expected to do to keep their property in good condition.  Suppose that when preparing to sell, you cleaned, painted, and hired a staging company to bring in furniture to stage the open house.  Cleaning and painting is not an adjustment to price or considered an advertising cost because it changed the house, but the cost to bring in, rent, and then remove the staged items, would be an allowable advertising expense because the actual house was not changed in any way.  

Let's do an example using similar numbers.

• Purchased for $85,000.  Had $1000 of closing costs that are allowable adjustments.
• Made $30,000 of improvements.
• Placed as a rental for 4 years.  You should have taken depreciation based on a cost basis of $115,000 (minus the value of the land).  Over 4 years, your depreciation would have been about $14,000.  This will be on your prior tax returns.  If you did not take depreciation, you must still include the depreciation you could have taken as an adjustment.
• Sold the home for $300,000, with an $18,000 commission and $4000 of staging expenses.

Your adjusted cost basis at the time of the sale was $102,000.  (Purchase price plus adjustments plus improvements minus depreciation.)

Your adjusted selling price was $278,000.

Your capital gains is $176,000.

Because $14,000 of the capital gains is due to recovery of depreciation, that is taxed as ordinary income with a maximum of 22%.  The remaining $162,000 of capital gains is taxed at the 15% long term capital gain rate.

[AmyC]

1. The time as a main home  before rental is mostly irrelevant. In 1997 , laws changed rental and main homes to be more defined so people couldn't move in and out and avoid taxes easily. Then the rules changed with the sale of main home exclusion and put hard limits on the moving back and forth. There are exceptions to the 2 year rule but they don't match your situation.  These factors,  according to Pub 523. 

You may qualify if you can demonstrate the primary reason for sale, based on facts and circumstances, is work related, health related, or unforeseeable. Important factors are:

• The situation causing the sale arose during the time you owned and used your property as your residence.
• You sold your home not long after the situation arose.
• You couldn’t have reasonably anticipated the situation when you bought the home.
• You began to experience significant financial difficulty maintaining the home.
• The home became significantly less suitable as a main home for you and your family for a specific reason.

2. @opus just chimed in with a great answer.

3. As MFJ, he will have the sale of main home exclusion while you have the sale of rental property both on your return.

[Opus 17 · Accepted solution]

@gtrkay 

The so-called hardship rule,

You may qualify if you can demonstrate the primary reason for sale, based on facts and circumstances, is work related, health related, or unforeseeable.

Can only be used to qualify for a partial exclusion if you don't meet the "owned for at least 2 years" part of the 2 year/5 year rule.  In other words, you don't meet the ownership rule because you had to sell early.  You do meet the ownership rule, you don't meet the residency part of the test, but the hardship rule does not extend the residency test.  The only thing that extends the residency test is if the reason you moved out is connected with military service.