Rental Conversion, Depreciation Recapture, and an Installment Sale
Single taxpayer, age 58, bought a house in 2005 for $400,000 and lived in it until 2019, when she moved to an apartment and rented the house. She claimed $120,000 of depreciation through 2024. She now has a contract to sell for $850,000, with $50,000 of selling costs. Her salary is $180,000, and she has $20,000 of interest and dividends. She wants to use the $250,000 home-sale exclusion, carry an installment note over five years, and “avoid the 3.8% surtax.” She has $60,000 of suspended passive losses from the rental. She is considering moving back into the house for two years before selling if that helps.
1. Is the $250,000 home-sale exclusion available? Compute the amount realized, adjusted basis, and character of gain.
Read the worked answer
No. She rented the home from 2019 through 2024, so she did not use it as a principal residence for at least two of the five years ending on the sale date. Amount realized is $850,000 minus $50,000 selling costs, or $800,000. Adjusted basis is $400,000 minus $120,000 depreciation, or $280,000. Total gain is $520,000. Of that, $120,000 is unrecaptured Section 1250 gain taxed at a maximum 25% rate. The remaining $400,000 is long-term capital gain. The Section 121 exclusion is unavailable on these facts. Moving back could restore eligibility, but the exclusion would be allocated for nonqualified use after 2009, and depreciation recapture would remain taxable. Do not assume the full $250,000 exclusion.
2. How would an installment sale over five years be taxed, and what happens to the suspended passive losses?
Read the worked answer
The installment method defers gain as principal payments are received, but depreciation recapture is not deferred. The $120,000 unrecaptured Section 1250 gain is recognized in the year of sale. The remaining $400,000 gain is reported pro rata as payments are received; interest is ordinary income. Selling costs reduce the amount realized. The $60,000 suspended passive losses are released in the year of complete disposition and can offset the passive gain from the rental, reducing net investment income. The 3.8% net investment income tax applies to the lesser of net investment income or modified AGI over the $200,000 single threshold; the gain increases AGI, and the passive losses reduce net investment income. Obtain a projection before choosing the note terms.
3. Should she move back into the house for two years before selling? Evaluate the tax and non-tax factors.
Read the worked answer
Moving back may satisfy the two-of-five use test, but Section 121 reduces the exclusion by the nonqualified-use fraction. With six years of rental out of roughly twenty-two years of ownership, only a portion of the gain would be eligible, and depreciation recapture would still be taxed. She would also lose rental income, incur moving costs, delay the sale, and bear market risk. Compare the tax saved with the cost of moving and delay. Alternatives include selling now and using the suspended passive losses, a Section 1031 exchange if she wants another rental, or a charitable gift of the property if charitable intent exists. She should not move back solely for tax reasons without a written projection and advice from tax counsel.