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A solo 401(k) plan in which the only participants in the plan are the business owners and spouses of course, the spouses are employees of the business...

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HOW MUCH GAIN WILL BE TAXABLE IF TAXPAYER CONVERTS RENTAL PROPERTY TO A PRINCIPAL RESIDENCE ?

 

General rule for excluded gain on sale of primary residence: If a taxpayer owns and uses the home for any two of the five years looking back from the date of sale, taxpayer may exclude $ 250,000 of gain (not sales price).  If only one taxpayer of a married couple meets the ownership and use test, the exclusion is up to $ 250,000 if both spouses meet the ownership and use test, the exclusion is up to $ 500,000.

Rental residential property converted to primary residence and later sold:

Before January 1, 2009. The above general rule applies in the determination of the excludeable gain.

Beginning for sales after December 31, 2008, the calculation of the amount of gain excludeable changed. The calculation is best explained by an example.

Taxpayers purchased a rental house on January 1, 2007. On January 1, 2014, the taxpayers converted the rental house to a primary residence. On January 1, 2016, the taxpayers sold the house for a $ 300,000 gain.

First, the period of ownership of the house must be bifucated into tow period-qualified and non-qualified use.

The qualified use includes the ownership period before January 1, 2009 coupled with the period the home was used as a principal residence. Thus, the qualified use consists of 2007,2008,2014 and 2015.

The non-qualified use includes 2009,2010,2011,2012 and 2013.

The amount of the $ 300,000 gain that is excluded is the ratio of qualified use to total period of ownership. The total ownership period is, therefore, nine years. The qualified period of ownership is four years. The percentage of the total gain is 44.44 (4/9). Thus, $ 133,320 of the $ 300,000 gain is excluded from income. The remaining $ 166,680 which represent depreciation taken while the house was rented is taxed at a maximum 25% rate. The $ 166,680 net of depreciation is long-term capital gains.

IMPORTANT EXCEPTION TO THE ABOVE.

If the house is used as a primary residence and afterwards converted to rental property, the rules are more favorable to the homeowners.The gains up to $ 250,000/$ 500,000 are excluded from income except the amount of post May 6, 1997 depreciation taken while the house was being rented. The "depreciation recapture" is taxed at a maximum rate of 25%. This exception to the above rule is well reasoned because there are occasions when the homeowners desire to sell the property. After the property has been on the market for a protected period of time, the property is rented until the housing market improves.

Warning: Remember, the home must be used as a principal residence for two out of five year looking back from the date of sale to qualify for the exclusion. Renting the property for more than three years destroys the exclusion.

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