When divorcing couples have one or more rental properties, sometimes the divorce settlement contemplates a spouse moving into one of them.  Usually the spouse moving in would be awarded the property as part of the settlement.  Here are some things to be aware of when considering moving into a rental property.

Tax Impact of Moving into a Rental Propertymoving into a rental property

First, you will probably clear out the tenants.  Hopefully they will go gracefully.  With them goes the rental income.  With them also go many of the tax deductions associated with the property.  This includes depreciation, costs of renting and repairs, and fees such as monthly homeowner’s dues.  The only deductions likely to remain will be mortgage interest and property taxes.

Nonetheless, moving into a rental property can be part of a tax strategy to reduce or eliminate capital gains tax when the property is eventually sold.  The IRS lets a single person exclude up to $250,000 in capital gains provided they have lived in the property for two of the last five years.  So if the property has appreciated in value while it was a rental, you might have a plan to avoid taxes on up to $250,000 in capital gains by moving into it for a couple years or more and then selling the property.

Sometimes divorcing spouses considering this option neglect to find out the current tax status of the property. This can be costly.  Three things are important:

  • what would the IRS consider to be the gain if the property is sold;
  • how much depreciation has occurred; and
  • approximately how much tax would have to paid upon a sale.

Many people mistakenly assume that the gain for taxation purposes would be essentially the market value of the property of the property minus the outstanding mortgage balance.  Actually the mortgage has nothing to do with it.  There’s a different formula the IRS uses to determine the gain.  If it is less than $250,000 and all other requirements are met, including the two year residency mentioned above, there may be little or no capital gains tax to pay.

Special Rule

However, a special rule enacted in 2009 limits the $250,000 exclusion for single homeowners who initially use their home as a rental property.   Here’s a simplified example:

You buy a house on January 1, 2009 for $275,000 and use it as rental property for four years. You then move into the house as your principal residence.  Six years later on January 1, 2019, you sell the property for $575,000.  For simplicity, you have a $300,000 gain on the sale.  The special rule says that since the first four of the ten years (40%) before the sale were a “non-qualifying use” (e.g. rental), 40% of your $300,000 gain ($120,000) does not qualify for the $250,000 exclusion. This means that in the year of the sale, you must add $120,000 to your taxable income for tax purposes.  Your remaining gain of $180,000 is less than the $250,000 exclusion, so it is excluded from your taxable income.

Depreciation Recapture

Alas, upon the sale of the rental property, the IRS will also “recapture” depreciation.  This applies whether or not you claimed the depreciation expense on your tax returns during the years of the rental.  The total depreciation during the rental period is not eligible for the $250,000 exclusion.  Instead, you pay a flat 25% tax on the total depreciation amount.

The IRS depreciates rental property over 27.5 years.  In the example above, a $275,000 property would be depreciated $10,000 per year for each of the four rental years.  So the total depreciation would be 4 times $10,000 = $40,000.  The depreciation recapture tax would be 25% times $40,000 = $10,000, payable in the year of the sale.

If your income is low enough, you can escape capital gains and depreciation recapture taxes but not the effects of the special rule enacted in 2009.

As you can see, the tax implications of moving into a rental property are considerable. This is a good area in which to get input from a Certified Divorce Financial Analyst or tax professional.