IRC Section 121 and Its Application to a Rental Property Turned Primary Residence
Investing in real estate can provide significant financial benefits, including capital appreciation and rental income. However, the tax implications of selling a property that has been used both as a rental and as a primary residence can be complex. This article will explore how the Internal Revenue Code (IRC) Section 121 exclusion applies when a rental property is converted into a primary residence, focusing on a detailed case study to illustrate the key points.
For more on the tax implications of selling rental properties, see Tax Implications of Selling a Rental Property – Gilbert Wealth
What is the IRC Section 121 Exclusion?
IRC Section 121 allows taxpayers to exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) on the sale of a primary residence, provided they have lived in the property as their main home for at least 2 of the last 5 years.
For example, assume you purchased a home as a primary residence for $200,000, lived there for 15 years, and then moved to another city selling your home for $450,000. Your capital gain on the home is $250,000.
Without the exclusion, you would be taxed at long-term capital gains rates on that gain disincentivizing you from moving which may be for a job. If your long-term capital gains rate were 15%, you would owe $37,500 in taxes upon moving!
The IRC Section 121 does away with this up to the limits to facilitate these types of changes in residence.
IRC Section 121 and Rental Property
If you own a rental property and convert it to a primary residence, IRC Section 121 does apply but, as with everything in the tax code, there are limitations and complications.
Let’s assume you purchased a rental property for $100,000. Over the course of 10 years, you depreciated the property by $25,000. At the end of the 10-year rental period, the market value of the property has appreciated to $200,000. You then decide to make the property your full-time residence for the next 2 years. During this period, the property value increases further, and you eventually sell the property for $220,000.
Are you able to able to exclude the entire $120,000 gain in the property due to IRC Section 121? No.
Depreciation Recapture
The first aspect to consider is the depreciation recapture. The $25,000 of depreciation taken during the rental period must be recaptured and is taxed separately. This recaptured amount is not eligible for the IRC Section 121 exclusion.
Qualified vs Non-Qualified Use
The second aspect to consider is qualified versus non-qualified use.
Qualified Use is defined as the period of time the property is used as a primary residence. In the above example, this would be 2 years.
Non-Qualified Use is defined as the period of time the property was not used as the primary residence. The exact opposite of qualified use. In the example, this would be 10 years.
IRC Section 121 is not allowable for gains related to Non-Qualified Use. To calculate the amount of gain attributed to non-qualified use, multiply the total gain of the property by the percentage the property had non-qualified use.
In the example provided, the calculation would be as follows:
Step 1) $220,000 sale price – $75,000 (adjusted basis) = $145,000 Gain
Step 2) 10 years of non-qualified use divided by 12 years owned = 83.34% non-qualified use
Step 3) $145,000 x 83.33% = $120,833 non-qualified gain
Step 4) $145,000 – $120,833 = $24,166 qualified for IRC Section 121 exclusion.
See How to Calculate Adjusted Cost Basis for a Rental Property – Gilbert Wealth
Bringing It All Together
The total tax for this transaction would be as follows:
Depreciation Recapture = $25,000 x 22% = $5,500
Long-Term Capital Gains = $95,833 x 15% = $14,375
Tax Free IRC Section 121 = $24,166 x 0% = $0!
Total Taxes: $19,875
When selling a property that was previously used as a rental and later converted to a primary residence, it is crucial to understand how the IRC Section 121 exclusion applies. In our case study, the gain eligible for exclusion under Section 121 is limited to $24,167, reflecting the period during which the property was used as a primary residence. The remaining gain, primarily attributed to the rental period, and the $25,000 depreciation recapture are not eligible for the exclusion.
This nuanced understanding helps taxpayers plan better and optimize their tax outcomes when dealing with mixed-use properties. Consulting with a tax professional can provide further personalized guidance based on specific circumstances.