Whether you want to sell investment properties and use the proceeds to buy a new house for yourself or you'd like to move into a rental property, you will face tax consequences. These vary depending on how you put the transaction together.
Drawbacks to Conversion
However you convert your property, when you sell it, the Internal Revenue Service gets its chunk. You can use the $250,000 or $500,000 capital gains exclusion as long as you live in the house for two years, but it may be limited. The IRS prorates your deduction based on how much time after 2008 the house was used as a rental and how much it was used as a residence. For instance, if you rented the house out during 2009 and 2010 and lived in it from 2011 through 2014, you'd have a six-year history. Since it was used as a rental one-third of the period, you'd have to reduce your exclusion by one-third. You could exclude $166,667 or $333,333 of any gain on profit, depending on if you're single or married. The depreciation recapture tax on the sale of an investment property also comes back when you sell your converted house. The IRS remembers how much depreciation you claimed on your property when it was a rental and requires you to pay it back through recapture tax when you sell.
Sell, Then Buy
The simplest way to roll your investment properties into a personal residence is to sell the properties, pay your taxes and use the proceeds to buy a house. When you do this, you'll have to pay capital gains tax on any profits you earned on your investment properties. If you sell these properties for more than their depreciated value, you'll also have to pay depreciation recapture tax on the difference between their depreciated value and either their selling price or their cost basis before depreciation, whichever is less. Doing this lets your replacement house be a pure personal residence, avoiding many problems when you sell it.
Exchange and Wait
If you have some time before you want to move, you can sell the investment properties and use the proceeds of the sale to buy the home that you eventually want to occupy for initial use as a rental. When you trade investment properties for investment properties and follow the IRS' rules under Section 1031 of the tax code, you carry your basis forward and defer your taxes. After a year, you can then convert the property into a personal residence. The IRS looks at these transactions carefully, so you should establish that you originally bought the residence as a rental.
Converting a Rental
However you convert the home into a rental, the rules are the same. You will have to stop filing Schedule E and claiming rental expense deduction, but you'll be able to claim your mortgage interest and property taxes on your Schedule A with your other itemized deductions. As long as you hold onto the home and don't sell it, you won't have to pay the capital gains or recapture tax.
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