How Living in a Property Before You Rent it Out May Be to Your Advantage

So we’ve come to the conclusion of my week-long answer to a reader’s questions about her rental property. Thanks again reader for providing so much material in one subject.

The last question in her email that I want to cover is, “How much profit would be tax free if we sold next summer.”

You may think from my discussion on Wednesday that she won’t be able to avoid tax unless she did a 1031 exchange for another investment property.

However, the key to this reader getting to exclude some gain comes from the fact that she and her husband used the property as a personal residence. That detail makes the analysis a little more complicated and gives them a possible way to avoid tax.  

The General Rule for Excluding Gain

You’ve likely heard the general rule for avoiding tax on gain on your personal residence: you can exclude up to $250,000 as a single person or $500,000 of gain as a married couple, if during the 5-year period ending on the date of sale, you owned the home for at least 2 years (the ownership test) and used it as your main home for at least two of the five years (the use test). You also can’t have excluded gain from the sale of another home during the two-year period on the date ending the sale.

The reader and her husband would meet the first and third prongs of this test, assuming a sale date of May 2015, but they wouldn’t meet the second since they only lived in the home for 10 months.

So they can’t exclude any gain right?


The Exception

As I’ve said time and again, with the tax code there’s usually a rule and an exception and most times an exception to the exception. The rule regarding excluding profit from home sale is no different.

In fact there are several exceptions where you can extend the ownership and use tests including:

  • Becoming disabled
  • The previous home was destroyed or condemned
  • You’re a member of the uniformed services or Foreign Service, employee of the intelligence community or an employee or volunteer in the peace corp.

There are also situations where you can get a reduced exclusion if you have to sell your home for the following reason:

  • Change of Employment
  • Health
  • Unforeseen circumstances

The reader’s husband is in the uniformed services, and they had to leave because of his job. Therefore, they still may qualify for the full or partial exclusion (I would need more information on their situation).

If they did decide to sell the property next May, they would have to report the sale on a Form 4797, since it was sold while being a rental. They also wouldn’t be able to exclude gain from the time they used the property as a rental (considered non-qualified use) or the amount of gain equal to the depreciation allowed.

Your Tax Advisor Can be Worth Her Weight in Gold

Obviously the reader has a lot of complexity to deal with when it comes to possibly excluding gain from the sale of her rental. I can’t take you through all the scenarios that could occur when trying to figure out how much to exclude in one post.  

I bring up these rules to at least familiarize you with them and give you the knowledge to ask about them. It also goes to show how beneficial a good tax advisor could be when it comes to complex matters like this.

I hope this week gave you a lot of new knowledge regarding renting and selling your real estate. For more in-depth reading on selling your property, check out IRS Publication 523.