If you sell a rental property that was your primary residence, you may experience a common problem for ex-pats. For example, you own a house in Los Angeles but have decided to move to San Miguel de Allende, Mexico. When you get to Mexico, you fall in love with the city, the culture, the people, the food, and the weather. Compared to Los Angeles, the winter in San Miguel never gets much below freezing, and the summer never gets much above 90 degrees. You find that the cost of living is about a third of the U.S., and you decide in an instant or years of visiting to live permanently in San Miguel and rent out the primary residence in Los Angeles.
Now, at some point in the next five years, you face a dilemma. If you lived in the house for two of the last five years and sold the house for a capital gain, you would exclude $250,000 each of the profit up to $500,000. When you convert from a primary residence to a rental, the clock starts over. You can offset the rental income with depreciation, but you will lose the ability to shelter the capital gains if you do not use the house for your primary residence two years of the next five.
According to KLR, Kahn, Litwin, Renza & Co, When you convert the property, you are eligible to depreciate the tax basis of the building portion (not the land) over 27.5 years. Depreciation is a great way to offset rental income without actually expending any additional cash. However, if you fail to use the property exemption, you could pay dearly.
KLR says, “It is essential to discuss your options with your tax advisor. The more facts and accurate timeline you can provide, the more options you will have when weighing your decision. This five-year timeline needs your special attention. You don’t want to lose your tax advantage, but if you make one or two small changes to the circumstances, you could net significant tax savings.
Here’s another example of selling a rental property that was a primary residence. A couple I knew would buy a house to flip. They would use the house as their primary residence while they updated the house. They needed to live there for at least two years. Then they would find another fixer-upper, move in and sell the first house. Mostly, they lived in each house rent-free.
Ain’t real estate grand?
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