Under Section 121 of the Internal Revenue Code, you may exclude gain from the sale of your principal residence if you meet certain ownership and use requirements. Specifically, you must have owned and used the property as your principal residence for at least two years during the five-year period ending on the date of the sale.
- Ownership and Use Requirements: According to Subsection 121(a), the property must have been owned and used by the taxpayer as their principal residence for periods aggregating at least two years within the five-year period ending on the date of the sale. This means that if you move into your rental property and live there as your main home for at least two years, you would meet the ownership and use tests.
- Exclusion Limits: Subsection 121(b)(1) states that the amount of gain excluded from gross income shall not exceed $250,000 for single filers. For joint filers, Subsection 121(b)(2) increases this limit to $500,000, provided certain conditions are met, such as both spouses meeting the use requirements and neither spouse being ineligible for the benefits of the exclusion.
- Frequency of Use: Subsection 121(b)(3) specifies that the exclusion can only be used once every two years. Therefore, you cannot have used the exclusion on another property within the two years preceding the sale of the rental property.
- Depreciation Recapture: If you used the property for rental purposes and claimed depreciation deductions, you must recapture the depreciation upon the sale. According to Subsection 121(d)(10) and the related Treasury Regulations, the exclusion does not apply to the portion of the gain equal to the depreciation deductions allowed or allowable for periods after May 6, 1997. This gain is subject to a 25% unrecaptured Section 1250 gain tax rate.
- Allocation of Gain: If the property was used partly for rental purposes and partly as a residence, you must allocate the gain between the business and residential portions. The gain attributable to the rental portion is not eligible for the exclusion under Section 121.
- Nonqualified Use: Any periods of nonqualified use (i.e., periods when the property was not used as your principal residence) may affect the amount of gain you can exclude. The gain allocable to periods of nonqualified use is not eligible for exclusion.
In summary, if you move into your rental property and use it as your main home for at least two years, you can exclude up to $250,000 (or $500,000 for joint filers) of the gain from the sale under Section 121, provided you meet all the other requirements. However, you will need to pay tax on the portion of the gain attributable to depreciation deductions taken during the rental period.
Sources:
Publication 523 (2023)
§ 121. Exclusion of gain from sale of principal residence
PLR 200601023
PLR 200936024
§ 1.121-1. Exclusion of gain from sale or exchange of a principal residence.
