Home Sale After Rental Conversion: §121, Depreciation, and the Reduced Exclusion
Ana and Luis, married filing jointly, bought their home in June 2013 for $350,000. Ana used 18% of the square footage exclusively as a home office from 2014 until February 2021 and claimed $42,000 of depreciation. In February 2021, Luis accepted a job 600 miles away; they moved out, converted the entire house to a rental, and never lived there again. They claimed $18,000 of additional depreciation during the rental period. They sold the house in June 2024 for $1,050,000, paying $50,000 of selling expenses. The rental produced taxable income each year. They have no other home sales in the past two years. They want to know how much gain is excluded under §121 and how the home office and rental period affect the result. They file jointly and have substantial other income.
1. Determine whether the §121 use test is met and whether a reduced exclusion applies.
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Section 121 requires ownership and use for at least 2 of the 5 years ending on the sale date. Ana and Luis owned the home since 2013, so the ownership test is met. The 5-year lookback is June 2019 through June 2024. They lived there from June 2019 until February 2021-about 20 months-so they fail the 24-month use test.
Because they moved because Luis took a job 600 miles away, they have a qualifying event for a reduced maximum exclusion under §121(c). The safe harbor treats a new place of employment as qualifying if it is at least 50 miles farther from the home than the old workplace; 600 miles easily satisfies it. The reduced maximum is $500,000 × (20 months ÷ 24 months) = $416,667.
The later rental period is not nonqualified use because §121(b)(5)(C) excludes periods after the property last served as the principal residence. So the rental period does not further reduce the exclusion, but the depreciation does.
2. Compute the amount and character of gain Ana and Luis must recognize.
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Amount realized = $1,050,000 - $50,000 = $1,000,000. Adjusted basis = $350,000 - $60,000 total depreciation = $290,000. Realized gain = $710,000.
Of that gain, $60,000 is unrecaptured §1250 gain attributable to depreciation and is not excluded under §121(d)(6); it is taxed at a maximum 25% rate. The remaining gain is $650,000. The reduced §121 exclusion of $416,667 applies to that remaining gain.
Recognized gain = $60,000 + ($650,000 - $416,667) = $60,000 + $233,333 = $293,333. Character: $60,000 unrecaptured §1250 gain; $233,333 long-term capital gain. The $416,667 excluded amount is not reported. The 3.8% NIIT may apply to the recognized gain if their MAGI exceeds the threshold.
3. Explain how the home-office depreciation and the rental period affect the exclusion, including the nonqualified-use rule.
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The $42,000 of home-office depreciation and the $18,000 of rental depreciation both reduce basis and create unrecaptured §1250 gain. Section 121(d)(6) denies exclusion for gain attributable to depreciation, so the $60,000 is recognized regardless of the reduced exclusion. The office was within the dwelling unit and was used exclusively; the remaining gain on the entire property is eligible for §121, subject to the reduced maximum. The rental period does not create nonqualified use because it followed the last period of principal residence use. If the office had been a separate structure, the analysis of the office portion could differ, but the depreciation recapture would still be recognized.