Since the exchange already happened, you don't "report" the conversion itself as a taxable event in the year you move in. However, the move presents a set of rules you must follow to preserve your tax benefits for when you eventually sell. Here are some things you need to consider before selling your house at a future date.
1. The Two-Year "Safe Harbor" Rule
Before you move in, you must ensure you’ve met the holding period requirements. To satisfy the IRS (under Revenue Procedure 2008-16), the property must typically be treated as an investment for at least 24 months immediately following the exchange.
- In each of those two 12-month periods, you must have rented the property at a fair market rate for at least 14 days.
- Your personal use of the property during those two years cannot exceed 14 days or 10% of the days it was rented.
2. Reporting the Change in Use
There is no specific tax form to "notify" the IRS that you are moving in. Instead, the reporting change happens on your Schedule E:
- You simply stop reporting rental income and expenses for that property as of the date you moved in.
- Depreciation stops: You can no longer claim depreciation once the property is no longer used for business/investment.
3. The Five-Year Ownership Rule
If you eventually sell this home and want to claim the Section 121 exclusion (the $250k/$500k gain exclusion), you cannot do so after only two years of residency. For properties acquired via a 1031 exchange, you must own the property for at least five years before you can claim any primary residence exclusion.
4. Calculating Gain Upon Sale (The "Gotchas")
When you finally sell the home, you won't get the full tax exclusion you might expect. You have to account for two things:
Depreciation Recapture
Any depreciation you claimed (or could have claimed) while it was a rental must be "recaptured" and taxed at a flat rate of 25%. You cannot "exclude" this portion of the gain.
Non-Qualified Use
Under the Housing Assistance Tax Act of 2008, you must pro-rate the gain based on "qualified" vs. "non-qualified" use.
- Non-Qualified Use: The time the property was a rental.
- Qualified Use: The time the property was your primary residence.
Example Calculation: If you owned the home for 10 years total—5 years as a rental and 5 years as a primary residence—only 50% of the gain (after depreciation recapture) is eligible for the $250k/$500k exclusion.
I know this information may be overwhelming but this is a fairly complex issue with many nuances. Knowing what to expect will mitigate any surprises when or if you sell your house at a future date.
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