Capital Gains Exclusion for Unconditional Use of Property

Financial Planning Tax Strategies
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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

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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.

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)

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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

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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.

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 Wealth Management

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.

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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

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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.

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

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

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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

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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

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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

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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

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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

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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

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So it’s now a year later and the house is on the market. We are reconsidering selling and back to trying to figure out what our options are without losing capital gains exclusion.

To recap, we have lived here as our primary residence for almost 5 years. It is where our stuff is, where our doctors are, where we vote, where we return to after travelling. After doing a deeper dive into what constitutes a primary residence, I have read examples stating essentially that it is where you spend the majority of your time. It’s OK to be away for months at a time, as long as you are not in another specific state for longer than the time you are at your primary. So we could spend 4 months here and the other 8 in various other places, as long as we were not in one specific state for more than the 4 months we were here. Sorry, but no link for this.

Our house has a 1 bedroom self-contained in-law suite, and a 3 bedroom residence. They are both connected internally with a stairway with a locking door, which allows for the house to be a 4 bedroom when the door is unlocked. We would keep the property fully furnished, pay the utilities and maintenance.

One options we understand not to impact our capital gains exclusion is doing home exchange. Via Homeexcchange.com, we can do direct swaps or allow people to stay here for points, which we can then use to travel where we wish to go. This type of activity is not considered federally taxable, and even gets around local restrictions of stays under 30 days. We have significant regulations against AirBnB type activity here, and I have confirmed this to be an acceptable use of the property. There will be no taxes of any kind associated with this use.

The second option is for us to move our personal use stuff to our vacation home and rent out both units in the 30+ day furnished rental market via FurnishedFinder.com. This would trigger the need to do depreciation, and start the clock to close on the sale of the property within 3 years, retaining the capital gains exclusion as it is understood at this time. If we sold within those 3 years, we would have to recapture depreciation, but still have the $500K capital gains exclusion available to us. As needed, we could use whichever unit was vacant here under the personal use of rental property of 14 days or 10% rented, per unit. If this went on for more than 3 years, we would then have to prorate the capital gains exclusion between the time it was a primary, and the time it was rented.

These are the two scenarios I feel I understand. Please, however, point out misunderstandings.

What I am foggier on is what happens if we keep our primary residence in one of the units, or rent for a couple of years and then go back to living there, with the entire property as our residence. Other than having to prorate expenses and depreciation between the ratio of the two units, does it impact our capital gains exclusion timeframe if we still live in part of the home, or come back to the home after renting?

Other than home exchange, what are our options that preserve capital gains exclusion?

Appreciate your input.

IP

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Consult a tax professional who is familiar with rentals. All of the scenarios you outline seem rather aggressive in trying to keep the capital gains exclusion, so I’m not convinced that any of them will actually work if questioned by the IRS.

AJ

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No worries. This is only a starting point and am not looking to anyone here for a definitive strategy for us to follow.

This is kind of like video watching on YouTube to see how to do something before calling the professional. It helps you figure out which questions to ask the professional.

IP,
who wouldn’t make decisions solely based on what someone says on the internet, regardless of how long one has interacted with them

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There’s a general problem with tax professionals. And that is that you choose which professional to use and follow their advice. So, if you want an aggressive solution, you may seek out an aggressive-minded professional. If you want a more conservative solution, you may seek out a more conservative-minded professional.

Seems like lately the IRS and the tax court have been looking more at the intent rather than simply the mechanics of transactions and statuses. If they determine that the intent was solely to preserve the capital gains exclusion, and all the machinations around renting short-term, etc weren’t normal business practice, they could potentially invalidate the whole thing and force it to be treated with normal rental property treatment. For example, they could look at home exchange as follows - if you do home exchange for 2 weeks or a month or even two months, then it is usual practice of home exchange for people who want to experience life elsewhere for a period of time, but if the total is multiple months, that is not the usual practice of home exchange and was done solely to avoid the long-term rental aspect of the transaction. And they would perhaps have sufficient stats to back this opinion up.

An average HomeExchange member stays in exchanges for 14 nights a year

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The intent of traveling around is to find a place we want to live. Most people don’t sell their residence until they find a new place. In the meantime, you can’t leave a place vacant. Tends to invalidate insurance. If we can populate the place without triggering capital gains exclusion, or even better with getting a benefit from it, all the better. From your link:

Hosting has the benefit of having trusted travelers take care of your home while you’re away, too. “It gives you peace of mind knowing that your house isn’t sitting empty for three months at a time and you have no idea what’s going on,” Erica said. "Knowing that someone is there and taking great care of your place is one of the reasons we love it.”

We are also just considering getting a house sitter. Avoiding loss of capital gains exclusion is a side effect that we want to prevent, not a primary reason for our plans. We want to travel, but home has to be somewhere. Insurance won’t allow for empty houses long term. Something has to give.

IP