How to Convert Rental Real Estate to Residential and the Tax Implications

Proper conversion of rental property to personal property can elimate capital gains tax.

Job transfers and losses are just a couple of the reasons that people convert the primary residence to rental property. Over time, if the situation that caused the property rental changes, the owners may wish to move back into the rental home and reclaim it as the primary residence. While you are welcome to move back into your property at any time the home is unencumbered by an executed lease, you should be aware of the tax implications of the sale of the home at a future date. Proper planning can help you reduce or even eliminate capital gain taxes from the sale of a previous rental property.

Things You'll Need

• Purchase paperwork for home
• Home improvement receipts
• Tax returns for rental property

Instructions

Convert Property to Personal Use

1. Move into your property that was previously rented and change all your personal information, such as driver's license, insurance and mail, to reflect the address of the property.

2. File with the county/parish for homestead exemption, if it is offered in your area. Homestead exemption is a legal transaction that verifies you are using the home as your primary residence.

3. Remain in the home for a minimum of two years of the five years preceding a sale of the home. For example, if you rented the property from January 2001 to December 2007 and moved back in the home January 2008, you must remain in the home until December 2010 in order to avoid capital gain taxes on the entire profit from the sale of the home. The Internal Revenue Service (IRS) considers a property personal use if it is occupied by the owner a minimum of two years of the five years prior to a sale. If the property was properly converted to personal use by the two-year residence rule, you can exclude the first $250k ($500k if filing jointly) of profit from the sale from capital gains tax.

Calculate Profit on Sale

1. Determine your basis in the property. Your basis in the property is your cost of the property plus closing costs on the loan plus any improvements made to the property that have a useful life of more than one year, such as roof or air conditioning replacement. Basic repairs are not considered improvements to the property.

2. Reduce your basis in the property by all depreciation claimed on your tax return while the property was rented. Other reductions to basis include items such as casualty losses previously taken as a tax deduction and certain residential energy credits. Refer to IRS publications for exact rules for calculating basis for the year you sell your home.

3. Subtract your adjusted basis calculated in Step 2 from the sales price of the home. If the gain on the sale is less than $250k ($500k if filing jointly), you do not owe capital gains tax on the sale of the home.

Tips & Warnings

• If you are not certain how to properly convert rental property to personal property, or you are not certain if you can safely sell your home without incurring capital gains tax, consult a tax professional prior to listing your home for sale.

References

• Internal Revenue Service: Sale of Residence--Real Estate Tax Tips
• Internal Revenue Service: Publication 523