We bought our primary residence in 1994 for $144,000 and lived in it for 11 years. In 2005, we moved out of the country to take a job in Asia and rented our home.
We thought we were converting our personal residence into an investment property so that we could keep our foot in the door of the housing market. The home’s value at that time was $444,000.
We’ve rented the house since 2005 and have been depreciating it at the cost basis of $144,000. The current tenant has offered to buy the house for $430,000. The entire gain on the house occurred during our time residing in the home. I believe the entire gain is non-taxable since it occurred while we lived in the home.
Should I have adjusted the basis in the home at the time of conversion?
If you had never rented your home, you and your wife would be entitled to exclude from federal income taxes $500,000 in profit from the sale. But the rule that allows this exclusion requires the home seller to have lived in the home for at least two out the five prior years.
It seems that the IRS would consider your home to be an investment property. You don’t qualify for $500,000 exclusion, as you have not lived in the home for about eight years. If you had sold the home in 2005, you could have excluded any profit from the sale of the home at that time. You elected to keep the home, rent it, and now you want to sell it.
For federal income tax purposes, you will have to pay taxes on the profit you make on the sale of the home. That is the difference between your cost basis and the sales price of the home, which in this case is $430,000, a different of about $300,000.
When you file your federal tax return, you may also have to pay taxes on any depreciation you took while the property was rented. You say that in your tax returns you depreciated the home using a value of $144,000. You’d have to talk to an accountant or tax preparer to see if you should have used that number or not.
Since the year you first rented the home, you have received a tax advantage on your federal income taxes by depreciating the value of the home. Now, when you sell, you’ll have to repay the IRS. Generally speaking, if you received about $4,000 in depreciation benefits for each of seven years, you took a total of about $21,000 in depreciation. (We’ve assumed quite a bit here, but if you actually took $21,000 in depreciation, you probably owe taxes back to the IRS on that amount at the rate of 25 percent.)
You also will owe the IRS cash on the $300,000 profit you earn from the sale of the home. Given the large amount of capital gains potentially at stake, depending on your income level, your capital gains tax rate should be either 15 percent or 20 percent. That would mean you either owe $45,000 or $60,000 on the sale of the home plus the $5,000 or so for the depreciation recapture. These amounts are no small sum of money.
In addition, due to the changes in the tax laws earlier this year, you will also have to pay a surcharge of 3.8 percent on investment income or another $11,400 in taxes.
The only way you could have prevented this situation was to have sold your home in 2005 and not rented it.
The best way we know that you can now defer paying federal income taxes upon the sale of this property is to use a like-kind exchange or 1031 tax deferred exchange. In a 1031 exchange, you would sell this property and then buy a replacement property of equal or higher value. You must abide by certain timing rules and must use a qualified 1031 exchange company to complete the sale and purchase, but you’d defer paying any taxes until you sell that other property down the line. You could continually defer taxes by holding the next property throughout your life, leaving it to your heirs, or by selling and buying other like-kind properties, all inside 1031 exchanges, throughout your life.
The only exception that we know of for those in your situation is if you or your husband were members of the uniformed services, foreign service or intelligence community. In that case, the rule that states that you must have lived in your home for two out of the prior five years is extended and starts up upon your return to the United States. But the five-year running period can’t be extended more than 10 years, which in your case means time would run out in 2015, if you qualify.
The only other option would be for you and your spouse to move back into your home and make it a primary residence for the next two years. Then you would once again be able to claim that a portion of the profits should be tax-free. But you would have to break the agreement with your tenant, and we’re not at all clear if moving back into this property is even on the table.
For more details, please consult with your tax preparer or real estate attorney.
Ilyce R. Glink’s latest book is “Buy, Close, Move In!” If you have questions, you can call her radio show toll-free (800-972-8255) any Sunday, from 11 a.m. to 1 p.m. EST. Contact Ilyce through her Web site, www.thinkglink.com.