June 1, 2014
When a divorcing couple has two properties the separation can be made easier when one party takes the principal residence and the other takes the vacation home. This may seem like a cut and dried decision, but there is an important tax issue to consider when converting a rental property to a personal residence.
The allure of owning a vacation home for many is the opportunity to rent it out and use the rental income to cover expenses. One of the allowable expenses of rental property is depreciation. The IRS allows you to divide the cost of the property over 27.5 years and deduct that amount each year as an expense (other improvements to the property may have different depreciation periods). The flip side, however, is that when the property is sold all depreciation is taken off the cost of the house, resulting in a larger gain. Some homeowners choose not to deduct depreciation thinking that by doing so they won’t have to deduct it from their cost at the time of the sale. But the IRS doesn’t allow that – even if you don’t take advantage of the depreciation deduction you will still have to deduct the allowable depreciation from the cost of the house at the time of sale. Let’s look at an example:
Hugh and Scarlett buy a rental home for $687,500 in 2004. They rent it out for 10 months of the year and stay in it for 2 months in the summer. Each year on their tax return they deduct $25,000 ($687,500 divided by 27.5) as depreciation. Today, after 10 years of ownership, they get divorced and sell the house for $987,500. Their cost basis is $687,500 less $250,000 ($25,000 x 10 years) for a new cost basis of $437,500. Thus the gain in the house is $550,000.
If this had been their primary residence there would have been no depreciation of course, and the cost of the home would be $687,500 for a total gain of only $300,000. With a primary residence you can realize a gain of $250,000 (if you are single) or $500,000 (if you are married) before any capital gains tax is assessed. If they sold the house while still married there would be no tax owed. If Scarlett sold it as a single taxpayer she would owe capital gains tax on only $50,000.
But this is a rental property so there will be tax owed on the gain. The IRS says that a rental house is an investment property and therefore you must pay capital gains tax of 15% as you would on other investments such as stocks and bonds.
Hugh comes up with a clever plan to avoid the tax: what if Scarlett moved into the rental house and lives there for 2 years prior to selling? Then it would be her “primary residence” and not an investment property! Not so fast, Hugh – while the IRS does define a “primary residence” as a house you have lived in for 2 of the last 5 years prior to selling, when converting a rental property to a personal residence there is a glitch: even if Scarlett lives in it for 2 full years she won’t be afforded the full $250,000 allowance (remember, she is single now so she is subject to the $250,000 allowance.) This is because a portion of the profit will be taxed, equal to the ratio of the time the house was not the principal residence after 2008 (when the rules changed) to the total time of ownership.
So if Scarlett lives in it for 2 years (from 2014 to 2016), then the house would have been a rental property for 5 years of ownership after 2008, and her total time of ownership is 12 years. 42% of the profit (or $126,000) is not eligible for tax-free treatment. Scarlett would owe $18,900 in capital gains tax.
This is important to know because including the full amount of equity on Scarlett’s side of the asset-debt worksheet is misleading - she is going to lose some of that equity due to taxes when she sells the house.
In a divorce situation where rental real estate is part of the asset division, make sure you understand the full cost of ownership and any impending tax liability.
Use of any information in this newsletter is for general information only and does not represent personal tax advice either express or implied. You are encouraged to seek professional tax advice for personal income tax questions and assistance.
