Little Known Law Can Reduce the Excludable Gain on Your Residence
December 2nd, 2021 at 7:28 PM
Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married joint-filing couples.
Unfortunately, legislation enacted back in 2008 included an unfavorable provision for sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege.
The Non-Excludible Gain
Let’s call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows.
Step 1. Take the total gain and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income. Carry the remaining gain to Step 3.
Step 2. Calculate the non-excludable gain fraction.
The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualified use.
But periods of non-qualified use don’t include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance.
Periods of non-qualified use also don’t include times when the property is not used as your principal residence if those times are
- after the last day of use as your principal residence, and
- within the five-year period ending on the sale date. (See Example 4 below.)
The denominator of the fraction is your total ownership period for the property.
Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.
Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997, from Step 1. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.
Overly complicated federal income tax rules create a lot of taxpayer confusion, so let’s consider the following examples that illustrate how to calculate non-excludable gains from principal residence sales.
Example 1. Dan, a married joint-filer, bought a rental property on January 1, 2001. On January 1, 2016, he converted the property into his principal residence and lived there with his spouse from 2016 through 2021.
On January 1, 2022, Dan sells the property for a $600,000 gain, including $50,000 of depreciation deductions claimed for the 15-year rental period (January 1, 2001, to December 31, 2015).
Dan must report the $50,000 of gain attributable to depreciation deductions—the unrecaptured Section 1250 gain—on his 2021 federal return. That gain is subject to a maximum federal rate of 25 percent, plus another 3.8 percent if the gain is hit with the NIIT.
Dan’s remaining gain is $550,000 ($600,000 - $50,000).
Dan’s total ownership period is 21 years (2001-2021). The seven years of post-2008 use as a rental property (2009-2015) result in a non-excludable gain of $183,333 (7/21 x $550,000). Dan must report the $183,333 as a long-term capital gain on his 2021 Schedule D.
He can shelter the remaining $366,667 of gain ($550,000 - $183,333) with his $500,000 gain exclusion.
Example 2. Claudia, a married joint-filer, bought a vacation home on January 1, 2013.
On January 1, 2017, she converted the property into her principal residence, and she and her spouse lived there from 2017 through 2021.
On January 1, 2022, Claudia sells the property for a $600,000 gain. Her total ownership period is nine years (2013-2021).
The four years of post-2008 use as a vacation home (2013-2016) result in a non-excludable gain of $266,667 (4/9 x $600,000). Claudia must report the $266,667 as a long-term capital gain on her 2022 Schedule D.
She can shelter the remaining $333,333 of gain ($600,000 - $266,667) with her $500,000 gain exclusion.
Example 3. Same basic facts as in the preceding example, except this time assume that Claudia has $10,000 of unrecaptured Section 1250 gain from renting out the property before converting it into her principal residence.
Therefore, the total gain on the sale is $610,000. Claudia must report the $10,000 of unrecaptured Section 1250 gain on her 2022 Schedule D.
She must also report the non-excludable gain of $266,667 [4/9 x ($610,000 - $10,000)] on her 2022 Schedule D.
She can shelter the remaining $333,333 of gain ($610,000 - $10,000 - $266,667) with her $500,000 gain exclusion.
Example 4. Gary is a married joint-filer. He bought a vacation home on January 1, 2013. On January 1, 2016, he converted the property into his principal residence and lived there with his spouse from 2016 through 2019.
He then converted the home back into a vacation property and used it as such for 2020 and 2021.
Gary then sells the property on January 1, 2022, for a $540,000 gain.
His total ownership period is nine years (2013-2021). The first three years of post-2008 use as a vacation home (2013-2015) result in a non-excludable gain of $180,000 (3/9 x $540,000). Gary must report the $180,000 as a long-term capital gain on his 2022 Schedule D. He can shelter the remaining $360,000 of gain ($540,000 - $180,000) with his $500,000 gain exclusion.
Key point. The last two years of use of Gary’s property as a vacation home (2020-2021) don’t count as periods of non-qualified use because they occur
Therefore, Gary’s use of the property as a vacation home in 2020 and 2021 doesn’t make his non-excludable gain any bigger. Good!
Mark S. Fineberg, CPA