Due to the precipitous decline in the housing market over the past few years, many homeowners who would otherwise sell their homes are renting them out. This may be because prices are too low, or because they have to move before they can sell due to a job change.
Such accidental landlords should understand that if they rent out their homes too long before they sell them, they could lose the biggest tax break available for most people: the home sale exclusion.
Homeowners who qualify for the home sale exclusion don’t have to pay any income tax on up to $250,000 of the gain from the sale if they’re single, or up to $500,000 if they’re married and file a joint return. Of course, this exclusion is useful only for homeowners who have equity in their homes, not the millions who are "under water" and will receive no profit if they sell their homes.
To qualify for the exclusion, a homeowner must satisfy the ownership and use tests. This means that during the 5-year period ending on the date of the sale, the homeowner must have:
- owned the home for at least 2 years (the ownership test), and
- lived in the home as a primary residence for at least 2 years (the use test).
However, the homeowner need not be living in the house at the time it is sold. The two years of ownership and use may occur anytime during the five years before the date of the sale.
This means that a homeowner can move out of the house for up to three years and still qualify for the exclusion. Moreover, a homeowner can rent out a home and count that time as ownership time.
This rule has a very practical application: A homeowner may rent out a home for up to three years prior to the sale and still qualify for the exclusion. However, the exclusion works a bit different for homeowners who have rented out their homes.
They cannot exclude from their income the part of their gain equal to the depreciation they claimed (or could have claimed) while renting the home. Moreover, if the home is rental property at the time of the sale, the sale must be reported to the Internal Revenue Service on Form 4797: Sales of Business Property.
Example: Connie purchases a house on Feb. 1, 2007, and lives in it for two full years. She then moves to another state to take a new job. Rather than sell the house in a down market, she elects to rent it out.
If she sells the house by Feb. 1, 2012, she’ll qualify for the $250,000 home sale exclusion because she owned and used the house as her principal home for two years during the five-year period before the sale. If she waits even one more day to sell, she will get no exclusion at all.
Thus, accidental landlords who have equity in their homes need to sell them before the three-year rental period expires, or they’ll lose the home sale exclusion. If they can’t or don’t want to sell, they would have to move back into the home to preserve the exclusion.
Homeowners who don’t qualify for the exclusion will have to pay a 15 percent capital gains tax on their gain from the sale (assuming the home was owned for at least one year).