How to Reduce Capital Gain Tax on The Sale of The Second and Rental Homes.

There is a  misconception about the tax strategy for 2nd or rental homes. Tax payer can move to rental home, live in it for two years before selling it  in order to get full exclusion for the gain of $250,000 for single filer or $500,000 for married jointly couple. Reducing the capital gain tax on rental or 2nd home sale requires a right strategy to take the advantage of IRC §121 and its exception.

Many of you may hear about IRC §121 exclusion which the taxpayer can exclude the gain up to $250,000 or $500,000 for married filing jointly.  I also discuss about this provision in the another post.  You can read How to Minimize Tax on the Sale of Your Primary Residence

This is one of good strategies; however, this is a big misconception that many people don’t know.  The fact is  taxpayer will NOT get the full $500,000 exclusion

New 2008 requirement

Before 2008, one strategy is to convert the 2nd home or rental home to primary residence for two years prior to selling and take the full $250,000 or $500,000 gain exclusion. In 2008, congress introduces a requirement to prevent people from  abusing the IRC §121.  

After 2008, the strategy is still working but it is not as lucrative as before.  For individuals who own more than one home, the primary residence is where they spend most of their time and there is only one primary residence during a particular year.  under the new law, the time that the taxpayer is not using the home as his/her primary residence  is non-qualified use and the gain of the non-qualified used is treated as the capital gain.  In other words, if the taxpayer has some periods of time when  he/she is not using the home as the primary residence, he/she will never get the maximum of $250,000 or $500,000 exclusion.

One of the requirements of IRC §121 is to use the home as primary residence 2 out of 5 years leading to the home sell.  This requirement is to determine whether a taxpayer is eligible for the exclusion.  If he/she is not eligible, the entire gain will be taxed as capital gain.  Therefore, it’s very crucial to understand the new requirement to reduce the gain tax for rental home sale. 

What is Non-qualified Use?

Non-qualified use refers to any periods during which the home was used as a rental,  investment property, or 2nd home and not as primary residence by a taxpayer.  However, there are exceptions to the period of non-qualified use:

• Any period after the last day home was used as the primary residence by a taxpayer until the date of sale. Also, such period should be within 5 years before the date of sale.
• Any period (not more than 10 years) during which a taxpayer served on qualified official extended duty.
• Any other period of temporary absence (not more than 2 years) due to health conditions, change of employment, or other unforeseen circumstances (as provided in law)

Non-qualified Use Formula

As for the new tax rule, a taxpayer cannot exclude the portion of gain which belongs to non-qualified use of primary residence from the gross income for tax purpose.

A = Total numbers of days after 2008  the taxpayer does not use the home as the primary residence

B = Total number of days the taxpayer owned the home (counting all days, not just days after 2008)

Non-qualified Use = A/B

Gain allocable to non-qualified use = non-qualified use x Gain on the sale of  property

Gain exclusion = (1 – Non-qualified Use) x Gain on the sale of property

Illustrations

Taxpayers X and Y, a married filing jointly couple, bought a home on January 1, 2003 for $450,000.

• Lived in the home until December 31, 2005.
• January 1, 2006 to December 31, 2012, moved out and rented the home
• From January 1, 2012 to December 31, 2016, moved back and lived in the home
• January 1, 2017 to December 2018, moved out and rented the home
• On January 2019, the couple sold the house for $1,500,000
• The depreciation claimed on the home when rented was  $150,000

How much X and Y will recognize on sale of the home? and How much they can exclude on their gross income per IRC §121? How to reduce capital gain tax on 2nd or rental home sale?

Gain Computation

Cost Basis	$450,000
Less Depreciation	($150,000)
Adjusted Basis (c)	$300,000
Sale Price (d)	$1,500,000
Realized Gain (d – c)	$1,200,000

Depreciation Recapture: $150,000. No exclusion considered for depreciation and depreciation recapture of $150,000 tax at preferential rate of 25%

Gain to be considered for exclusion: $1,050,000

X and Y meet the requirement for IRC §121 because they owned and used the home as their primary residence for 2 out of 5 years prior to the sale. So the remaining gain is $1,050,000

Gain Allocable to Non-qualified Use

The next step is to determine how much gain belongs to the period of non-qualified use and cannot be excluded from the gross income.

The non-qualified use is the total number of days after 2008 when X &Y don’t used the home as a main residence.

• From January 1, 2003 to December 31, 2005 lived in the home: Qualified Use, 3 years
• From January 1, 2006 to December 31, 2012, moved out and rented the home:
  • Qualified use (before 2009): 4 years
  • Non-qualified use (after 2008): from January 1, 2009 to December 31, 2012: 4 years
• From January 1, 2012 to December 31, 2016, moved back and lived in the home: Qualified Use, 5 years
• From January 1, 2017 to December 2018, moved out and rented the home. This period is not considered non-qualified use because of the exception that it is the period after the home was last used as the primary residence but before the date of sale

A = Total numbers of days after 2008  the taxpayer does not use the home as the primary residence = 5 years

B = Total number of days the taxpayer owned the home (counting all days, not just days after 2008) = 16 years (from January 1, 2003 to January 1, 2019)

Non-qualified Use = A/B

Non-qualified Use = 4/16

Since the maximum exclusion for a married filling jointly couple is $500,000, $500,000 is used to calculate non-qualified use gain

Gain allocable to non-qualified use = 4 x $500,000/16 = $125,000

Results

In summary, there is a $150,000 depreciation recapture tax, $125,000 of gain allocated to non-qualified use and $375,000 of gain excluded from the gross income

For simplification, assume the taxpayers long-term capital gain tax rate and depreciation recapture tax rate are 15% and 25% respectively. Please see the below table which will illustrate the comparison between old and new law

	Under old law	New law in 2008
Realized Gain	$1200,000	$1,200,000
Depreciation	($150,000)	($150,000)
Gain before exclusion	$1,050,000	$1,050,000
Exclusion	$500,000	$375,000
Gain after exclusion	$550,000	$675,000
Depreciation Recapture (25%) Tax	$37,500	$37,500
Long-term capital gain (15%) Tax	$82,500	$101,250
Total Tax	$120,000	$138,750

Under the old law, X and Y would have excluded $500,00 from their gross income. However, under the new law, X & Y will now be able to exclude a gain of only $375,00 . As per the new law, the non-qualified use period starts only from January 1, 2009. Therefore, X and Y could exclude gain from January 1, 2006 to December 31, 2008.

Author’s Recommendations

In summary, non-qualified use causes the reduction of the $250,000 or $500,000 (married filling jointly) exclusion or taxpayers pay more taxes.

Many taxpayers have multiple homes. Taxpayers may hit a big tax bill without proper planning. Below is one of strategies to reduce the capital gain tax on the sales of 2nd or rental homes that I often advise my clients to take the advantage of IRC §121 by meeting the residence requirement and minimize the non-qualified use

• Live in Home 1 as the primary residence for > 2 years (1)

• Sell Home 1 immediately OR rent it our or make it as the 2nd home for < 3 years (2)

• Live in Home 2 as the primary residence for > 2 years after (1) period (3)

• Sell Home 2 immediately OR rent it our or make it as the 2nd home for < 3 years (4)

• Continue all these steps for the 3rd, 4th home, and so on

Following these steps, taxpayers meet the residence requirement of IRC §121 which is 2 years as primary residence out of the last 5 years to the closing date. Taxpayers can also meet the exception of being non-qualified use for the last 3 years ((2) and (4)) in which all five-year period will become qualified use for gain exclusion calculation. So the maximum of $250,000 or $500,000 (married filling jointly) gain exclusion from the gross income can be achieved.

Please note that, besides the last 3-year period which meets non-qualified use exception, other periods that the taxpayer doesn’t live in the home as primary residence will be considered as non-qualified use.