How to Convert Rental Property to a Principal Residence for Capital Gains

Selling your home is a much better tax deal than selling a rental house. When selling your rental, you pay tax on your gain -- roughly the difference between your purchase price and sales price. When it's your home, you can exclude $250,000 in gain from tax; married couples can sometimes exclude up to $500,000. To turn rental property into a personal home, you just have to live there a while.

Ownership and Use

To qualify for the primary-home tax break, you have to own the house at least two years out of the five years before the sale. You have to live there two out of five years too, but it needn't be the same two years. If, say, you're a tenant there for three years, then buy it and rent it out for two years, you've met both tests. To get the full $500,000 deduction, only one of you has to own the house, but both of you have to live there.

Exceptions

You don't have to hang your hat in the house every night for two years to earn the tax break. If you take a two-month Christmas vacation elsewhere every year, for instance, it doesn't affect your exemption. If you're on active duty in the military and stationed at least 50 miles away from your home, time away from the house doesn't affect the exemption unless you're gone more than 10 years.

Rental Property

The IRS imposes special rules on houses that you rent out. When you've used the house as a rental rather than just a second home, you may not be able to take the full exclusion, even if you move in long enough to qualify. If, say, you buy and rent out the house starting January 1, 2009, move in at the start of 2013 and sell two years later, you have two years of personal use and four years of rental use. Because two-thirds of your ownership was rental, you can only exclude one-third of the gain.

Special Cases

If you sell before two years of ownership are up, you may still get a limited deduction. The IRS allows this if you move for work, move to care for an ill family member or you suffer something truly out of the blue, such as the house getting seriously damaged. A special case that works against you is if, in the two years before you sell, you used the gain exclusion on another sale. In that case, you can't exclude gain a second time.

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About the Author

A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.

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