Q: I have an unusual home sale situation and wonder if you know the answer. I bought a house in Boulder, Colorado, in 1994 and lived in it until 2001, when I relocated to Albuquerque. It is very close to the University of Colorado campus, and rather than selling I started renting. I rented continuously until 2011, when my daughter started as a student at the university. She then lived in the home until June of 2015, when I started renting again. The house has significantly appreciated, and my wife and I are considering going back to Boulder and moving into this house. The house is currently vacant, and we are doing a remodel to update the kitchen and bathrooms before we move in. So what’s odd is this was my house, then a rental, then used by my daughter, then a rental, and maybe my house again. If we were to move back to the house for at least two years, would we then be able to claim the $500,000 tax exclusion for gains? The gain is going to be huge, and I would definitely make the move if I could save the taxes on sale.
I can answer your question, but the answer requires me to take you through a few steps. Usually a home sale question is easy, but as you note you have several changed circumstances along the way.
First, the tax law allows you to exclude from income any gain from the sale of a property that was owned and used by you as a principal residence for at least 2 of the 5 years before the sale. This exclusion is $500,000 if you are married filing a joint return.
You compute the gain by taking the cost of the house, plus any capital improvements you make, and then reducing that by the depreciation that you claim during any periods of rental. When the property is sold, any portion of the gain caused by claiming depreciation is not eligible for the exclusion.
Second, this provision is effective as of May 6, 1997, and that date affects the determination of the exclusion amount. So while depreciation-induced gains are not eligible for exclusion, it is only depreciation claimed after May 6, 1997, that is reported as income when the property is sold.
Third, the benefits of the exclusion were reduced in 2008 legislation for any property that was rented before it is used as a residence. The exclusion will not apply to any periods of “nonqualified use,” which means non-residence use that occurs after 2008.
Since you didn’t give me numbers, I’ll just make some up to illustrate how these rules work. Let’s say that you bought the house for $120,000. You claimed $60,000 of depreciation. After you live in it for 2 years, the home could be sold for $560,000.
A simple computation of the gain would be $500,000. That is the assumed sales price of $560,000 minus the $60,000 tax basis of the house, with the basis determined by subtracting the $60,000 depreciation from the $120,000 cost.
This gain is within the allowed $500,000 exclusion. But we have a few issues to address. In order, the tax law first requires that the depreciation-induced gain be recognized. Of the $500,000, $60,000 is because depreciation was claimed ($440,000 was an increase in value).
This depreciation gain must be recognized, but only the amount claimed after May 6, 1997. Let’s say that is $40,000 of the $60,000. That means $40,000 of gain is recognized.
Next, the remaining $460,000 gain ($500,000 – $40,000) is not eligible for the exclusion to the extent it relates to “nonqualified use.” That is the period of non-residence use after 2008. Let’s say that is seven years (your daughter’s use may be residence use). Your total ownership period would be, let’s say 28 years, after you live in it.
Then 25% (7/28) of the use is nonqualified, so that 25% of the gain may not be excluded. The gain remaining after the depreciation is $460,000, so $115,000 cannot be excluded.
Using my example, total gain of $155,000 is recognized. This is the post-May 6, 1997, depreciation and the gain allocated to the post-2008 rental period.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.