Capital Gains Exclusion for Unconditional Use of Property

[inparadise]

Please bear with me through this rather rambling post. I tend to think outside of the box which is often not the traditional way of doing things and can make it difficult to figure out the ramifications of what we are considering doing. Would appreciate feedback on what those may be from a capital gains tax exclusion POV.

We have a considerable amount of capital gains on our primary residence. We are looking to relocate, though we don’t know where to at this point and expect to be traveling extensively to get first hand experience in some areas we are considering.

We cannot sell the house for at least another year, having claimed capital gains exclusion on the sale of a house last year. One can only claim capital gains exclusion every two years. We had lived in that house for two years and then rented it out for the following almost 3, at which point it was sold. Was a nice surprise to discover we still qualified for 100% exclusion and it was not prorated. I am obviously not a tax pro, and would prefer not to be surprised this time around, nice or not.

In considering our options for what to do with our current residence, I am trying to better understand the tax implications of our choices. For the rest of this year, we have a young woman moving into the downstairs apartment to housesit, while we maintain the upstairs as our primary, retreating there in between excursions. We are not charging rent and picking up utilities, paying for lawn, etc. She is simply our eyes and ears and mail forwarding, providing signs of life to the otherwise vacant home.

We are hesitant in this period of inflation to sell the property next Spring, particularly with a 2% FRM, unless we have found a place to move to. We have every expectation that the property will continue to increase in value, due to local markets. Since we are staying months at a time in our travels, it could take a few years to vet these possible future places to live, and are looking at what our next steps could be. We have considered the following:

1. Keeping the upstairs as our primary residence, rent out the downstairs apartment. If we sell within 3 years we should still have the full $500K exclusion available to us. If it takes longer than 3 years to sell, we would lose part of the exclusion? What if we only rent the lower unit for 3 years and then take it off the market and remain here as a primary?

2. Rent out both units for up to 3 years. We would still have lived there 2/5 years. If the property needed to be fixed up at the end of the leases, I assume the time needed to bring the property back up to prime would count against our rental time and need to be done within the 3 year timeframe from move out to sale.

3. Rent lower unit as a long term rental and our upstairs unit as a 30 day plus furnished rental, possibly staying here in between travel. Or not.

I do realize that there are more tax implications here than just capital gains exclusion, but that is the area of taxation I am concerned with in this post. If you wish to post on loss of other tax benefits fbo other readers, please go ahead, but I would appreciate the thread staying on the capital gains tax exclusion topic.

TIA!

IP

[aj485]

@inparadise

We cannot sell the house for at least another year, having claimed capital gains exclusion on the sale of a house last year. One can only claim capital gains exclusion every two years.

Be careful on this - it’s not just a particular year, it would need to be at least 2 years and 1 day after you closed on the sale of the previous home.

@inparadise

Keeping the upstairs as our primary residence, rent out the downstairs apartment. If we sell within 3 years we should still have the full $500K exclusion available to us. If it takes longer than 3 years to sell, we would lose part of the exclusion? What if we only rent the lower unit for 3 years and then take it off the market and remain here as a primary?

I would question whether keeping it as your ‘primary residence’ actually meets the residency test if you are staying away months at a time. Months at a time does not seem like a vacation or a ‘short absence’ especially if you are only back for a short time between being away. From IRS Pub 523 2022 Publication 523 (irs.gov)

So if you want to actually meet the residency requirement to be eligible for the full exclusion, I would strongly suggest that you have documentation to show that you both were in actual residence for a minimum of 730 days during the prior 5 years before closing.

Renting part of the property, or even the full property for some/ all of the 5 years does not take away from the $500k exclusion limit. It does, however, limit the part of the capital gain from the house that is eligible to be excluded, so you would have to have well over $500k in capital gains to use the full limit.

AJ

[inparadise]

@aj485

I would question whether keeping it as your ‘primary residence’ actually meets the residency test if you are staying away months at a time. Months at a time does not seem like a vacation or a ‘short absence’ especially if you are only back for a short time between being away.

It would still be where our doctors are, the cars are registered, where we file taxes from, where our furniture is kept, and where we vote. Everywhere else we went would have none of the above. My parents lived full time in a motorhome for 10 years and had a PO box as their legal address for tax purposes. They owned no home at the time, with their Good Sam’s membership providing them a “home base” where they never actually stayed at. Definitely not conventional, but there must be some way to apply a “home base” for tax records in these cases. Granted, this was in the 1980’s, and things were different.

@aj485

Renting part of the property, or even the full property for some/ all of the 5 years does not take away from the $500k exclusion limit. It does, however, limit the part of the capital gain from the house that is eligible to be excluded, so you would have to have well over $500k in capital gains to use the full limit.

Perhaps I misunderstood so please bear with me as this directly contradicts what I have read and what Turbo Tax told us. Order in which the residency and rental takes place seems to matter. Because the residence came first and the renting after we had it as a primary for 2+ years, as opposed to what used to be the play to avoid taxes by having a rental and moving into it as your primary for the last 2 years to avoid capital gains, there is According to Turbo Tax no nonqualified use of the home for these up to 3 of the past 5 years of rental:

"NONQUALIFIED USE OF A MAIN HOME

Simply described, “nonqualified use” means any use other than as a principal residence after December 31, 2008. So, for example, use as a second home, vacation home or rental is considered “nonqualified use” beginning in 2009 or later. However, “nonqualified use” does not apply to time that falls into one of the following categories:

1. Periods of time after its use as a principal residence.
   …

Here are a few examples:

1. After owning and living in it for several years, you move out of your main home on August 1, 2022, and rent it out for a year before selling it. The time it is rented out doesn’t count as “nonqualified use” because it is AFTER being used as a principal residence."

Another example I found was this: Because they lived in the house as their primary residence for at least two of the last five years, they still qualify for the Section 121 exclusion. In fact, because the rental period happened after they lived in the house as their primary residence, they don’t even need to prorate the gain between periods of qualifying and non-qualifying use as they would if they moved back into the rental property. The only income to be reported is the recapture of any depreciation that was taken during the rental period. Beware of the Tax Cost of Turning Your Primary House into a Rental Property | Merriman

Given order of primary residence seems to matter, I posted the possible scenarios on my OP. I guess the takeaway is that we could rent the property out for up to 3 years, including closing on the sale of the property, and still not lose the up to $500K capital gains exclusion. If after the 3 ish year rental period we decided to reconvert it to a primary residence, then we would have to deal with non-qualified and qualified time and prorate the amount of gain that could be excluded. We currently have close to $400K in gains, which is too much of a potential tax liability to get wrong by not knowing exactly what the scoop is.

Unfortunately I seem to have pressed something above this reply I am working on and am not sure if this will post. The whole thread seems to have disappeared.

[inparadise]

@inparadise

Unfortunately I seem to have pressed something above this reply I am working on and am not sure if this will post. The whole thread seems to have disappeared.

And we are back! I have no idea what happened but glad to see it’s here.

Another example of timing impacting qualified gains for exclusion would be our vacation home. We could move into it as our primary, live there for two years, and only get a fraction of qualified gains for exclusion based on the relative time it was a primary vs vacation home. This is because it was a vacation home first. We will have to 1031 exchange that one if we leave the area altogether.

Bloody complicated, but can’t get DH to give up the tax reigns to a CPA, which is why I am so grateful to all of you here as a check on future tax moves.

IP

[aj485]

@inparadise

It would still be where our doctors are, the cars are registered, where we file taxes from, where our furniture is kept, and where we vote.

I will repeat (edited to add bolding from original text):

If you were ever away from home, you need to determine whether that time counts toward your residence requirement. A vacation or other short absence counts as time you lived at home (even if you rented out your home while you were gone).

As I said, being gone for months at a time does NOT sound like a ‘vacation’ or ‘short absence’ to me. But it’s your tax return, so you can argue with the IRS if they question you.

@inparadise

Perhaps I misunderstood so please bear with me as this directly contradicts what I have read and what Turbo Tax told us.

At a minimum, any rental use of your property where you would be allowed to take depreciation (whether or not you actually claim the depreciation) results in recapture of the depreciation. Recaptured depreciation is not allowed to be an excluded gain, even if you haven’t used the entire exclusion.

AJ

[Goofyhoofy]

@inparadise

Because they lived in the house as their primary residence for at least two of the last five years, they still qualify for the Section 121 exclusion. In fact, because the rental period happened after they lived in the house as their primary residence,

Etc. etc. I read this as “sequential” [eg: after] not simultaneous. Maybe that’s irrelevant, dunno.

[aj485]

@inparadise

My parents lived full time in a motorhome for 10 years and had a PO box as their legal address for tax purposes. They owned no home at the time, with their Good Sam’s membership providing them a “home base” where they never actually stayed at. Definitely not conventional, but there must be some way to apply a “home base” for tax records in these cases. Granted, this was in the 1980’s, and things were different.

Yes, the rules changed in 1997. Under current rules, their residence would have been considered to be their motorhome - which is eligible to be considered as a home for purposes of the mortgage interest deduction, for instance.

AJ

[inparadise]

@aj485

Under current rules, their residence would have been considered to be their motorhome - which is eligible to be considered as a home for purposes of the mortgage interest deduction, for instance.

Interesting. How does that determine state taxes or vehicle insurance and fees/personal property tax? The PO Box was of course in the most tax advantaged state.

I can’t say it’s a lifestyle that appeals to me, however. Lived in a 17’ motor home for a year traveling across Europe with my 16 year old brother and parents. I was 12 at the time and my parents pulled us out of school to travel with them on their sabbatical. A little too much togetherness for me. In this day of AirBnB, I prefer to return to my apartment when I travel. Wimp, I know.

I will say there were some things we would have never experienced had we been under a roof without wheels rather than free camping. Woke up one morning to an international hang gliding competition going on overhead, which was very cool, but I would have been happy not to experience the two police in what was then Yugoslavia, waking us up in the middle of the night and wildly gesticulating with their machine guns, shouting FARENZIE, when Dad didn’t understand they were telling us to leave. Hard to misunderstand a machine gun sweeping from pointing at the van to down the road. May you live in interesting times!

IP

[inparadise]

@Goofyhoofy

I read this as “sequential” [eg: after] not simultaneous. Maybe that’s irrelevant, dunno.

Yeah, that’s why the questions. With taxes you have to get lost in the minutia.

I suspect we will simply sell next spring, with a firm closing date one day after our last sale with capital gains exclusion. This is an amazing place to own real estate, from an appreciation or rental POV, but as much as I love our house, I really don’t want to live here.

IP

[aj485]

@inparadise

Interesting. How does that determine state taxes or vehicle insurance and fees/personal property tax? The PO Box was of course in the most tax advantaged state.

Income taxes would be dependent on each state’s rules for income taxes. Back then, states were much less stringent about taxing travelers who were earning income while visiting their state. Now, many are starting to tax visitors as non-residents, with some even requiring businesses to withhold state taxes from the visiting employee’s paycheck. What are State Tax Implications for Traveling Employees? | SAP Concur I will note that states generally consider income from brokerage/bank accounts to be ‘earned’ in the state of the address on file for the account.

Personal/property taxes would be dependent on the state that they registered the motorhome in, and what the rules are there. Each insurance company sets the rules for what and where their insurance covers. When using the motorhome as a residence, different coverages can be required than if you are not living in it full-time, depending on the insurance company’s rules.

AJ

[inparadise]

@aj485

Income taxes would be dependent on each state’s rules for income taxes. Back then, states were much less stringent about taxing travelers who were earning income while visiting their state. Now, many are starting to tax visitors as non-residents, with some even requiring businesses to withhold state taxes from the visiting employee’s paycheck.

I can understand this in this day of WFH. They were retired, and constantly on the move, which is something we are considering as well. We will be gone for months at a time but a few weeks here, a few weeks there, returning “home” in 6-12 months. The only defined “primary residence” will be the house with all of our stuff in it, except us, unless we need to do a return trip for doctors appointments. It’s not always easy to live outside the box when regulations are trying to box you in.

IP,
who would love to do a loop of the US/Canada

[aj485]

@inparadise

I can understand this in this day of WFH.

The move toward doing this started well before the current WFH trend. The ‘jock tax’ that California charged Chicago Bulls players for the NBA Finals games they played in LA during the 1991 Finals kind of kicked it off, and as states went in search of revenue that wasn’t derived from their residents, it expanded to where it is now.

AJ