If you convert your home to a rental property, and then sell the property, you might still be able to take a Section 121 exclusion on some of the gain.
The Section 121 exclusion is available to homeowners who have owned and lived in the home at least two years out of the five years leading up to the date of the sale. What if you convert the property to a rental?
You own a house which you bought for $200,000. You move out of it but are unable to sell it, so you convert it to a rental property. Two years later you sell the property for $250,000.
Rental property is depreciated over 27.5 years because the IRS says so. $200,000 / 27.5 = $7,273 per year x 2 years = $14,546 depreciation. As in my last post, I am not accounting for pro-rated depreciation in the first and last years for the sake of keeping the example cleaner.
So when you sell the home, your gain is based on an adjusted basis of $200,000 – $14,546 = $185,455. The gain would be $250,000 – $185,455 = $64,545. The gain attributed to depreciation is $14,546.
Because you meet the two-out-of-five rule, you can exclude all of the gain EXCEPT the depreciation. So you can exclude $64,545 – $14,546 = $49,999 (due to rounding, it’s not a nice clean $50,000). You’d need to claim the depreciation as income, so $14,546. This would be “Section 1250” gain, just like in our home-office example, and subject to taxation as ordinary income up to a maximum rate of 25%.
Use Form 4797 to report the rental sale. You’ll use Part III on page 2 to report the full sale showing a gain, in full, of $64,545. Then in Part I of Form 4797, you’ll notate “Section 121 exclusion” and subtract out $49,999 of the gain.
You must meet the two-out-of-five rule on ownership of the home and usage as a primary residence. This means, when you move out, there’s a window of time (the next three years) where this method works. Otherwise you’re ability to take a Section 121 exclusion is gone.
Also, this only works when you have a home you covert to a rental property. Going the other direction, from a rental to a primary residence and then selling, opens up far more complications involving “qualified” and “non-qualified” usage.