Converting a rental or vacation home into a primary residence

In the wake of the COVID-19 era, a shifting real estate landscape has prompted some individuals to reassess their choice of residence and consider where they wish to embark on the next phase of their lives.  Whether driven by early retirement aspirations or the ability to work remotely, many CPAs’ clients may be contemplating selling their primary residence to either purchase another home or to relocate to their vacation or rental investment property.  This article delves into some tax intricacies associated with converting a rental property or a vacation home into a primary residence.

Exclusion of gain on sale of primary residence

axpayers selling their primary residence may be able to take advantage of the home sale exclusion under Sec.  121. Under Sec.  121, a taxpayer can exclude up to $250,000 ($500,000 if married filing jointly) from gross income on the sale or exchange of their primary residence, provided the taxpayer owned and occupied the home as their principal residence for an aggregate two-year period during the five-year period ending on the date of the sale or exchange.¹Only one principal personal residence sale every two-year period is allowed.² The tax savings can be substantial.

Example 1: Married taxpayers K and M buy a home on Jan. 1, 2016, for $310,000.  They use it as their principal residence until, after retiring, they move out of the home on Jan. 1, 2022.  On Dec. 31, 2023, they sell the property for $510,000.  The entire $200,000 gain on the sale qualifies for the exclusion under Sec.  121 because they owned and used the home as their principal residence for at least two years during the five-year period ending on the date of sale.³

An important point regarding married filers is either spouse can meet the two-year ownership requirement with respect to the property, but both spouses must meet the two-year use requirement. ⁴ The use of the residence need not have occurred while the spouses were married.

Example 2: K purchased a home in 2009 for $310,000 and began using it as his principal residence.  During 2020, M moves into the home, and they get married in 2021.  After working remotely for several years, the married taxpayers move out of the home on Dec. 31, 2022.  K sells the home for a $400,000 gain in 2023.  Neither K nor M has sold another house used as a principal residence within the last two years. The taxpayers file a joint return in 2023; thus, K can exclude the entire $400,000 gain from the sale, since K owned the house and both K and M used it as their principal residence for at least two of the five years before the sale.

Exclusion limited for vacation home converted to primary residence

For those taxpayers selling their primary home and moving into their vacation home, a future sale of the vacation home (new primary) may carry tax consequences. The Housing and Economic Recovery Act of 2008⁵ modified Sec.  121 to require allocation of gain to periods of “nonqualified use” of the home.⁶ Thus, classification of a home’s holding periods as either qualified or nonqualified is critical.  Qualified holding periods are when the taxpayer uses the home as their primary residence, as well as any portion of the five-year period preceding the date of sale that is after the last date on which the taxpayer uses the property as the primary residence.⁷

Otherwise, a period of nonqualified use is “any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer.”⁸ Note that any temporary absences from the primary residence for reasons such as employment, health, or unforeseen circumstances not exceeding in aggregate two years does not count as a nonqualifying period.⁹

The use of the property as a vacation home would be considered nonqualified use.  The taxpayer would recognize gain on the property allocated to those periods of nonqualified use.  Sec.  121(b)(5)(B) provides that this allocation is based on the ratio that the aggregated periods of nonqualified use during the period such property was owned by the taxpayer bear to the period such property was owned by the taxpayer.  Any period of nonqualified use occurring prior to Jan. 1, 2009, does not factor into the fraction.¹⁰

Example 3: Married taxpayers K and M purchased a vacation home in Florida on Jan. 1, 2016, for $310,000.  From Jan. 1, 2016, until Dec. 31, 2021, the taxpayers vacation in the home and reside in their principal residence in New York.  On Jan. 1, 2022, after retiring and selling their New York residence, they move to their Florida home and convert the vacation property into their principal residence.  On Dec. 31, 2023, they sell the Florida home for $510,000 and move into senior housing. Of the $200,000 gain on the sale of the Florida home, $150,000 is allocated to nonqualified use and is taxable as long-term capital gain ($200,000 gain multiplied by nonqualified use period of 72 months, divided by 96 months of ownership). The remaining $50,000 in gain is eligible for the Sec.  121 exclusion.

Rental property conversion to primary residence

As with vacation property, taxpayers moving into their rental property will face the same limitation of the exclusion for periods of nonqualified use under Sec.  121(b)(5)(A) when they ultimately sell that home.  While converting a rental property into a personal primary residence offers potential tax savings, other nuanced tax considerations are involved.  During the rental period, property owners typically claim depreciation deductions.  If taxpayers used all or part of their home for rental after May 6, 1997, they cannot exclude gain equal to the amount of depreciation allowed or allowable after that date.  If the taxpayers used all of the home for business or rental after that date, they may need to recapture some or all of the depreciation deductions they were entitled to take (i. e., their allowable deductions).¹¹ The rate is based on the taxpayer’s ordinary income tax rate and is capped at 25%.

Example 4: Married taxpayers K and M purchased a rental property on Jan. 1, 2016, for $310,000.  Depreciation taken on the property over the six years rented was $50,000.  On Jan. 1, 2022, the taxpayers convert the rental property into their principal residence.  On Dec. 31, 2023, they sell the home for $510,000. Total gain on the sale of the home is $250,000 ($50,000 is treated as ordinary income under Sec. 1250(b)(3) depreciation recapture, and the remaining $200,000 capital gain is allocated between qualified and nonqualified use). Specifically, $150,000 is allocated to nonqualified use and is taxed at the regular long-term capital gain rate ($200,000 gain multiplied by 72 months (2016–2021) divided by 96 months of ownership).  The remaining $50,000 is eligible for the Sec.  121 exclusion.

Transitioning a property into a personal residence also triggers a shift in deductible expenses.  During the property’s period as a rental, expenses such as homeowner insurance, repairs, and maintenance were deductible as business expenditures.  When the home becomes a principal residence, taxpayers lose those deductions but might be able to deduct real estate taxes and mortgage interest (previously fully deductible against rental income) as itemized deductions.

Passive losses

Another potential pitfall relates to passive losses.  Residential real estate activities are generally treated as passive, limiting the ability to deduct losses against other income sources.  Assuming the taxpayers are not rental real estate professionals or have not treated the rental as a nonpassive activity, they might find themselves in a pickle if they have a passive loss carryforward from their converted rental property and lack passive income.  A rental real estate professional is generally a taxpayer more than half of whose personal services in all trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates and who performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates.¹² Passive losses incurred during the rental period are typically deductible only to the extent of passive income (Sec.  469).¹³

However, the disposition of the property can lead to a “qualifying disposition” under Sec.  469(g).  This hinges on meeting three criteria: the disposal of the entire interest, a fully taxable event, and a transfer to an unrelated party.  If these criteria are met, losses allocated to the passive activity become fully deductible against nonpassive income unless basis limitations are present.  However, the application of Sec.  121 (home exclusion) complicates matters, because if the property sale qualifies for the home exclusion, the transaction remains partially taxable, and, thus, suspended passiveactivity losses remain unusable.

Example 5: Married taxpayers K and M purchased a rental property on Jan. 1, 2016, for $310,000.  On Jan. 1, 2022, the taxpayers convert the rental property into their principal residence.  The rental property had a $30,000 passive loss carryforward. On Dec. 31, 2023, they sell the home for $510,000.  This includes $200,000 of capital gain that is allocated between qualified and nonqualified use: $150,000 is allocated to nonqualified use and is taxed as regular long-term capital gain ($200,000 gain multiplied by 72 months nonqualified use divided by 96 months of ownership). The remaining $50,000 is eligible for the Sec.  121 exclusion.  This is an example of a partially taxable event, and, therefore, the suspended $30,000 of passive losses cannot be used to offset any of the gain in this transaction.¹⁴

In summary, navigating the transition of a property from rental to a personal primary residence involves a complex interplay of deductible expenses, potential pitfalls related to passive losses, and considerations such as the application of the Sec.  121 home sale exclusion.  This highlights the importance of careful tax planning.

A web of tax considerations

The decision to sell a primary residence to downsize or relocate introduces a complex web of tax implications, especially when transitioning into one’s current vacation home or rental property. Navigating these tax considerations demands a thorough understanding of Sec.121 and related provisions.  Individuals must be cognizant of the potential pitfalls, such as the impact of deductible expenses and the utilization of passive losses.  In any case, a taxpayer facing taxable gain should spend time maintaining detailed records documenting tax basis and all improvements to the property. As individuals change their place of residence for the next chapter of their lives, professional guidance that keeps them informed about the tax consequences of their choices remains paramount.

Footnotes

1.Secs. 121(a) and (b); see also IRS webpage, Topic No. 701, Sale of Your Home.

2.Sec. 121(b)(3).

3.Sec. 121(b)(2)(A).

4.Secs. 121(b)(2)(A)(i) and (ii).

5.The Housing and Economic Recovery Act of 2008, P.L. 110-289.

6.Sec. 121(b)(5)(A). See also Cockrum and Quilliam, “Sec. 121 Planning Opportunities After the Housing Assistance Tax Act,” 40 The Tax Adviser 162 (March 2009).

7.Sec. 121(b)(5)(C)(ii)(I).

8.Sec. 121(b)(5)(C)(i).

9.Sec. 121(b)(5)(C)(ii)(III).

10.Sec. 121(b)(5)(B). 

11.Secs. 121(d)(6) and 1250(b)(3); see IRS Publication 523, Selling Your Home. 

12.Sec. 469(c)(7)(B). See also IRS Publication 527, Residential Rental Property, and Lau, “Passive Loss Limitations on Rental Real Estate,” 235-4 Journal of Accountancy 20 (September 2023).

13.Sec. 469(c)(1) defines a passive activity as any activity that involves the “conduct of any trade or business, and in which the taxpayer does not materially participate.” The term “passive activity” includes any rental activity (Sec. 469(c)(2)).

14.Sec. 469(g); see also Chief Counsel Advice 201428008.

Contributor

Mary L. Cooper, CPA, DBA, is an associate professor of accounting at Utica University in Utica, N.Y. For more information about this article, contact thetaxadviser@aicpa.org.