My wife and are would like to downsize our personal residence and are thinking about moving into one of our investment properties after the sale of our home. The investment property is the first one I ever purchased and is the only one titled in our name. We have owned it nearly 10 years. My remaining properties are titled in the name of my LLC. I am unsure if the title particulars will make any difference. We expect to live there at least 2 years. How is depreciation recapture handled in such a case? I know that if you live in a property for 2 of the previous 5 years that any capital gains from the sale of the property are tax free but how would tax on the depreciation recapture be handled? Are there any strategies that could be used to reduce/eliminate the depreciation recapture, if any? We haven’t started the process yet so we can still implement tax optimization strategies if any are available. Thanks for any help you may be able to provide.
Depreciation Recapture When Converting Investment Property to Personal Residence
depreciation will stop when you convert the rental to your residence.
everything rides along until you dispose of the property. at that point, depreciation taken prior to use as your residence will be recaptured (technically, gain will be recognized to the extent of depreciation). Next, any period of “nonqualified use” will be determined. If you only live there 2 years, then 2/5 of any remaining gain will be excluded. If you live there 5 years, all the remaining gain will be excluded.
in short, you can avoid all of the gain by living there 5 years, but you’ll still have to recapture the depreciation. (Well… the lesser of depreciation or gain.)
You avoid depreciation recapture completely only if there’s a loss (no gain to recognize to the extent of depreciation). Any loss is still a loss.
Moving into you rental house is like letting your girlfriend move in with you and your wife. It has its advantages but it also has some disadvantages. Advantage is you already have the house and you don’t have to look for and buy a new house. Disadvantage is you lose the income and you complicate a clean balance sheet with investments personal items. I think the comments from mcwagner are the best way to look at the balance sheet issues.
Your period of non-qualified use, divided by your total years of ownership determines the percentage of your capital gain that will be taxed rather than excluded under Section 121. Periods of rental use from Jan 1, 2009 to the present are non-qualified use. Let’s say you converted the proeprty to yoru personal residence on Jan 1,2013. You would have 4 years of non-qualified use (Jan 1, 2009 -Dec 31, 2012). If you occupy the property as your primary residence for two more years, then sell, you will have owned the property a total of 12 years. Eight of those 12 years or 75% of your total period of ownship is qualified use, and hence 75% of your capital gain can be excluded from capital gains taxation under section 121.
With respect to your cost basis: when you convert the proeprty to personal use, your tax basis becomes the lower of the FMV of the property at the time of conversion or your adjusted cost basis. If your proeprty has declined in value to a point that is less than your adjusted basis, you use the lower value as your cost basis when computing your capital gain from the sale of your property.
As you have already been advised, depreciation is recaptured at a 25% tax rate.
Hope this helps.