Summary/TL;DR
Section 121 of the tax code permits substantial capital gains tax exclusions on the sale of a personal residence as long as eligibility requirements are met. Knowledge of the rules can also open additional doors such as temporarily turning your old residence into an investment property and enjoying the tax benefits of rental real estate.
Introduction
At some point in your life, you’re almost certain to need to move. Most people will find that simply selling their personal residence and using the equity to purchase a new home will be the best course of action. For one reason or another, however, you might hesitate to sell. Perhaps your old home is located in a fast-growing market or you want to keep it as a secondary residence. No matter what the reason, it’s important to be educated on what the tax code says about selling, renting, and keeping an old personal residence so that you can optimize your decision within it.
Today’s post is dedicated to this topic.
Section 121 – The Capital Gains Exclusion
The most important rule to be mindful of is the capital gains tax exclusion that sales of personal residences qualify for under Section 121 of the tax code. If your home is eligible for Section 121 treatment, then a large amount of appreciation will be exempt from capital gains - $250,000 for single taxpayers, and $500,000 for married filing jointly taxpayers.
Section 121 Eligibility
Eligibility for the maximum capital gains exemption under Section 121 is dependent on three tests – the ownership test, the use test, and the look-back test.
The Ownership Test – you must have owned your home for at least 2 years out of the last 5 years before the date of sale. If you are married filing jointly, only one spouse is required to meet the ownership requirement.
The Use Test – you must have used the home as your primary residence for at least 730 days (24 months) out of the last 5 years before the date of sale. The 730 use-days do not have to be continuous and can fall anywhere within the 5-year period preceding the closing date. Unlike the ownership test, both spouses in a married couple must independently meet the use test. If you had to leave your home due to physical or mental incompetence, you may use up to 1 year spent living in a care facility to meet the use test.
The Lookback Test – you must not have taken a capital gains exclusion on another home that was sold within the 2 year period preceding the date of sale.
If you aren’t eligible based on the three tests above, you still might be able to claim a partial exclusion if the main reason for the sale of your home was work-related, health-related, or due to “unforeseeable events”, a list of which are available in IRS Publication 523. Finally, if the home you’re selling was acquired in a 1031 like-kind exchange, you are generally disqualified from Section 121 eligibility unless the sale is taking place within 5 years of the acquisition date of your home.
Rules For Renting Your Old Property
You might want to know what your options are for keeping your home as either a vacation home, rental, or both. Fortunately, a variety of options exist that can be pursued with each of these options while retaining Section 121 eligibility.
The Augusta Rule
Section 280A of the Tax Code allows homeowners to rent out their home for up to 14 days per year without having to report the rental income on their tax return. This rule has been utilized by residents of Augusta, GA during the annual Masters tournament and, consequently, has come to be known as “The Augusta Rule”. As long as the property being rented is a residence (including a second home or vacation property) of the taxpayer, it is eligible for the Augusta Rule.
The Augusta Rule is a good fit for those who want to use their residence personally, therefore disqualifying it from treatment as a rental property. If you have a business, you could even rent the property to your business for meetings, retreats, parties, etc, to generate tax-free income as long as the property is not the company’s primary place of business. Finally, as long as the property is sold within a timeframe that still qualifies it for the ownership, use, and lookback tests discussed above, it will be eligible for the maximum capital gains tax exclusion under Section 121.
Renting For More Than 14 Days
If you want to convert your property into a full-time rental to generate more income, you’ll have a lot more to consider. First, whether the property will be a short-term or long-term rental will need to be decided. In both cases, as long as the property is sold within three years of you moving out, it will be eligible for Section 121 treatment, although any amount of capital gain attributable to depreciation will be excluded and subject to depreciation recapture. Furthermore, as long as the property has been rented for long enough to be considered an “investment property” (about two years), you’ll have the option to sell it in exchange for another investment property via a 1031 Exchange, in which case the entire capital gain (including what’s attributable to depreciation) will be tax deferred!
If you intend to use your old home as a vacation home and also convert it into a rental, you must carefully navigate the IRS rules for personal use of a rental property in order to avoid disqualifying the property from 1031 Exchange eligibility. In general, if you use the home for personal use more than the longer of 14 days or 10% of the total days you’ve rented it to others (per calendar year), then the IRS will consider it a “home” and it will not only be excluded from 1031 Exchange eligibility, but it will also force you to divide expenses related to the home between “personal” and “business” use, potentially eliminating some of the tax benefits involved in having the home as a rental.
Finally, as long as the new property is used as an investment property for a minimum period of time (most tax advisors I’ve talked to say 2-3 years), then you can convert it into a primary or secondary residence with no tax consequences! This means that you could conceivably rent your old property for a couple of years, purchase a new home that you intend to make your future residence by selling the old property via a 1031 Exchange and, after renting your old property for a few years, move into it or use it as a secondary residence after having paid no capital gains and having no depreciation recaptured!
All of the above pertains to both short- and long-term real estate rentals. The biggest differentiators between the two are the rules behind their definitions and how each option treats passive losses. These is discussed in more detail below.
The Short-Term Rental “Loophole”
Short-term real estate rentals (think AirBNBs or VRBOs) can be a great investment in certain markets and currently qualify for a “loophole” that allows for highly advantageous tax treatment. In order to take advantage of this “loophole”, you must ensure two things – first, the property must qualify as a short-term rental and, second, you must materially participate in its management. Qualifications for both requirements are discussed below:
Short-Term Rentals – a rental property qualifies as a short-term rental if the average rental stay is seven days or less OR the property has an average rental stay of 30 days or less and “substantial services” (such as daily cleaning, transportation, meal provision, etc) are provided to guests during their stay.
Material Participation – there are seven separate criteria that can be used to establish material participation in a rental property, but only three are common for short-term rental owners:
You spend over 500 hours per year on the business
You do “substantially everything” for the business
You spend over 100 hours per year on the business, and no one else’s time commitment surpasses your own
There are a lot of rules that govern material participation, so you want to be sure you work with a qualified CPA who knows the rules and can make sure that you qualify.
The principal advantage of short-term rentals is that any losses produced by the property can offset ordinary income. When combined with cost segregation studies and bonus depreciation, this “short-term rental loophole”, as it’s come to be known, can be an exceptionally powerful tax saving tool. When the property is sold, however, any income offset by depreciation will be recaptured at a maximum rate of 25% unless a 1031 Exchange is pursued.
Long-Term Rentals
The final option is to convert your old personal residence into a long-term rental property. Like short-term rentals, you can rent a property to long-term tenants for up to 3 years and remain eligible for the Section 121 capital gains exclusion. When the property is sold, the portion of capital gains attributable to depreciation will be subject to depreciation recapture up to a maximum rate of 25% unless a 1031 Exchange is pursued. Unlike short-term rentals, any losses generated by the property will be considered passive and can therefore only be used to offset passive income (rents), not ordinary income (pretty much everything else) unless you qualify as a Real Estate Professional, which is a subject beyond the scope of today’s post.
Professional Tax Help Is Essential
Clearly, the law pertaining to this subject is a bit of a minefield – there are plenty of opportunities for overlooking a small technicality that can ruin an entire plan. You must ensure that you are complying with the letter of the law every step of the way and documenting it all. Professional counsel from a CPA, financial planner, and tax attorney are non-negotiable steps before even thinking about acting on any of the advanced strategies discussed above.
