During ownership, a property ma be used as a rental property or as a principal residence. Capital gains tax implications upon a change in status of the property from rental property to principal residence are the focus of this article.

As a Rental Property

As a rental property any gain on sale must be treated as ordinary income regardless of the length of holding period and whether it is the first sale or a subsequent sale (except for the exchange of like-kind assets). That is because rental property is treated as a business asset.

On the other hand, as a principal residence, the gain on the sale is not recognized as long as the next purchase of a residence is made within two years after the last sale, except for the case where the adjusted sale price of the old residence exceeds the cost of the new one. In such a case, capital gain is recognized to the extent of this excess Sec. 1034(a). The non-recognized capital gain on the old residence is deferred to serve as a reduction of the cost of the new one, but this reduced cost of the new residence must not be lower than the cost of the old residence. This treatment is always true no matter how long the old residence had been held.

If the owner of a principal residence acquired a new residence within two years after the sale of the old residence, the capital gain on the first sale can be deferred. However, if this taxpayer again sold the new residence less than two years after the first sale, and purchased a third residence, the capital gain between the price of the second sale and the cost of the new residence can no longer be deferred to serve as a reduction of the cost of the third residence. However, the capital gain on the first sale for the difference between the price of the first sale and the cost of the old residence can still be deferred to serve as a reduction of the cost of the third residence Sec. 1034(d). The only exception to this rule is the situation where the second residence was sold due to employment relocation. The two-year waiting time does not apply to the first sale. In other words, the homeowner can own a first residence for less than two years, sell it and replace it, and is still entitled to the deferral of capital gain.

Example: Mr. Jones purchased residence No. 1 on January 1, 1980 for a cost of $100,000. On July 1, 1980 he sold residence No. 1 for a price of $110,000. On August 1, 1980 he purchased residence No. 2 for a cost of $130,000. On February 1, 1981 he sold his residence No. 2 for a price of $160,000. On March 1, 1981 he purchased residence No. 3 for a cost of $200,000. What is the taxable capital gain in 1980 and 1981, respectively? And what is the basis of residences No. 2 and No. 3 respectively? See Figure 1.

The taxable capital gain in 1980 is zero because the entire $10,000 gain ($110,000 - $100,000) is deferred even though Mr. Jones owned his residence No. 1 for less than two years. As a result, the basis of residence No. 2 is $120,000 ($130,000 - $10,000). The total accounting capital gain on the sale of residence No. 2 in 1981 is $40,000 ($160,000 - $120,000). However, since he waited only seven months (from July 1, 1980 to February 1, 1981) which is less than the required two years of waiting period after the first sale (July 1, 1980), the $30,000 ($160,000 - $130,000) capital gain on the sale of residence No. 2 cannot be deferred. The $10,000 capital gain on the sale of residence No. 1 can be deferred. As a result, the taxable capital gain in 1981 is $30,000 ($40,000 - $10,000). The basis of residence No. 3 is $190,000 ($200,000 - $10,000).

If, during the period of ownership, the status of principal residence was changed to the status of rental property, and the property was thereafter sold, the total capital gain throughout the entire ownership period must now be treated as ordinary income regardless of how long the property has been owned in either status (1988 Publication 523). If the status of the property is changed in this way, the taxpayer is treated as voluntarily giving up rights of capital gain exclusion for the principal residence. The tax benefits of capital gain nonrecognition for residence have been forfeited. Since this is ordinarily disadvantageous, it should only be done after consideration of potential benefits.

Is The Reverse True?

If the status of the property was changed from rental property to principal residence and the property was thereafter sold for a gain and also replaced, can the taxpayer claim nonrecognition of the gain for the residence? If so, an owner could reduce taxes by changing a rental property to a principal residence shortly before it is about to be sold. The capital gain on the rental property would be deferred.

As mentioned, for the taxpayer to be able to defer the capital gain on the sale of a principal residence, there must be a wait of at least two years from the date of purchase. The change of status from rental property to principal residence is considered as a sale of the property. Thus, the two-year waiting period becomes mandatory Sec. 1034(d).

If the status of a property has changed from rental property to principal residence and this residence was thereafter sold and replaced with a new residence, the total gain throughout the entire ownership period can be deferred to serve as a reduction of the cost of the new residence if the following conditions are met:

1. The owner has resided there for at least two years since the change of status; and

2. A new residence is purchased within two years after the sale. If any condition is not met, the entire gain must be treated as ordinary income. Under any circumstances, the depreciation previously taken as a rental property is always subject to recapture.

Example: On January 1, 1987 Mr. Smith purchased a house for a cost of $100,000. He rented the entire house to a tenant and took depreciation on the straight-line method for 27.5 years with $20,000 salvage value for the land. On January 1, 1988 he terminated the lease with his tenant and moved in with his family. On January 1, 1990 he sold this house for a price of $150,000. On February 1, 1990 he purchased a new residence for a price of $180,000. What is the taxable capital gain in 1990? And what is the basis of his new residence?

This house must be treated as a rental property in 1987 and as a principal residence thereafter. The depreciation taken in 1987 was $2,909 ($100,000-$20,000)/27.5, and no depreciation thereafter. The basis on January 1, 1990 when it was sold was $97,091 ($100,000 - $2,909). Therefore, the total accounting capital gain was $52,909 ($150,000 - $97,091). However, since Mr. Smith and his family have been living there for two years since the date of change of status on January 1, 1988, to the date of sale on January 1, 1990, and the new house was also purchased within two years on February 1, 1990, after the date of sale, this $52,909 capital gain will not be recognized as ordinary income in 1990. Instead, it will be deferred to reduce the cost of the new residence. Therefore, the basis of the new residence on February 1, 1990 is $127,091 ($180,000 - $52,909). Had he sold the house on December 1, 1989, the total accounting capital gain of $52,909 would have been treated as ordinary income in 1989 because it had been only 23 months after the change of status, which is less than the required 24 months of waiting period. The basis of his new residence would have been $180,000.