Selling a Home That Was a Former Rental
Stott Real Estate, Inc. is not licensed to provide legal or tax advice. Licensed professionals such as attorneys or CPA’s should be consulted for such advice.
President Bush signed the Housing and Economic Recovery Act of 2008, commonly referred to as the Housing Stimulus Package, into law 7/30/08. A provision in the law to minimize cost may impact negatively on absentee owners planning to convert former or second homes into their primary residence as well as on those that intend to occupy homes acquired via a 1031 exchange. The new law reduces the capital gains taxes that can be excluded when the property is sold, as the amount of the tax exclusion will be adjusted by non-residence use of the property such as having it be a rental property or a second/vacation home.
Homeowners that are selling a property they have used as a principal residence for at least two out of the five years prior to the sale can exclude up to $250,000 of gain if they are single and up to $500,000 of gain if they are married. The two years do not have to be consecutive and there are exceptions when a change of employment, health problems, military service or some other unforeseen circumstance occurs. This provision applies to Section 121 of the Internal Revenue Code and is often referred to as “the 121 exclusion.”
Commencing 1/1/09 owners that convert a rental property or second home into a principal residence and then later sell that property via a 121 exclusion will need to multiply their gain by a fraction to determine the taxable portion of their gain as well as the amount eligible for exclusion. The numerator of the fraction will be the amount of time from 1/1/09 that the property is used as a rental property or second home. The denominator of the fraction will be the total number of years of ownership dating from the original acquisition date.
The law will obviously have no impact if the owner never sells their principal residence. However, we have found over the years that very few Oahu homes remain suitable for the same family over any extended period of time. Most families eventually will want to move to a different location, own a different sized home, have different features in their home, and/or change from a house to a condo or vice-versa. A couples' view often changes when they move from having children living in a home to being empty nesters.
For simplicity, I am using 1/1/yr for most of my dates such as when a property is acquired, converted to a principal residence or sold. In actuality, my understanding is that the total number of days is used in establishing periods of time for the fraction.
Owner Living on Oahu
From strictly a tax viewpoint, owners with equity should sell their home via a 121 exclusion and start over again with a new principal residence when they return to Hawaii. Exceptions may occur when a home is truly once-of-a-kind and not able to be duplicated or when there are strong emotional or family ties to a home.
Owner Living on the Mainland
If the owner relocated less than 3 years ago; i.e., if they have currently occupied the home for two out of the past five years and are eligible for a 121 exclusion, they should seriously consider selling, particularly in our current declining housing market. This will enable them to get the maximum exclusion. Otherwise, every additional day it is rented will reduce their exclusion. If you are in this situation, contact us to discuss your options. If your tenant has a long-term lease, it may be possible to buy them out of it.
Assume you bought a home as a principal residence 1/1/03 and rented it 1/1/07, you will have two out of the past five years as a principal residence until 1/1/10 and could qualify for a 121 exclusion up until that date. Assume you sell it 7/1/09, your fraction would be six months as a rental after 1/1/09 or ½ year divided by 6.5 years of ownership (1/1/03 to 7/1/09) for a fraction of 1/13. Therefore, you would need to pay taxes on about 7.7% of the gain.
If you choose not to sell it and reoccupy the home in three years or 1/1/12, you must occupy it for two years or until 1/1/14 to be eligible to sell via a 121 exclusion, Your fraction doing this would be 5 years of having it be a rental (1/1/07 to 1/1/12) divided by 11 years of ownership (1/1/03 to 1/1/14) or 5/11. Therefore, you would have to pay taxes on about 45% of the gain. Every year it’s a rental works against you and every year it’s your principal residence works for you but the effect of them are different because one goes solely into the denominator while the other goes into both the denominator and numerator; e.g., if rental time were increased by a year with no change in residency, the fraction would be (5+1) or 6 divided by 11+1 or 12 or 50%; if only the residency time were increased by a year, the fraction would be 5/12 or about 42%. To get the fraction to the 7.7% in the preceding paragraph, it would have to be your residence for 54 more years as 5/(11+54) = 5/65 = 1/13 = about 7.7%.
Another option would be to sell the former Oahu home (now a rental property) about a year prior to your return and conduct a 1031 exchange into a replacement home suitable for you to occupy as a principal residence. A 1031 exchange defers gain; i.e., all the gain in the former Oahu home will be shifted into the replacement home. You rent the replacement home for at least a year so it qualifies for the 1031 exchange and then occupy it as your principal residence for four years. A principal residence acquired by a 1031 exchange must be owned for five years to be eligible to sell it via a 121 exclusion. Your fraction doing this would be 1/5 or 20% or about half of what it would be in the preceding paragraph. Plus, you would have the opportunity to change/upgrade your principal residence; plus, each additional year you occupy it as your principal residence significantly decreases the fraction with a numerator of only one year; e.g., if you live there for nine years, the fraction would be 1/10 or 10%.