What are the tax implications of moving a primary residence into a rental house?

by Michael A. Gillen, CPA | Dec 12, 2018

If you move your primary residence into your rental house, how are the gains on the previous home taxed? Also, how are the rental home's gains handled (1031 exchange)?

Fundamentally, you have presented two questions, each with differing tax implications.

  1. When you convert your primary residence to a rental property, how is the gain taxed for federal income tax purposes?

Answer: When a taxpayer converts a primary residence to a rental property, no gain (or loss) is recognized at the time of conversion. At the time of conversion to a rental property, you must start to claim depreciation. For depreciation purposes, the tax basis of the converted rental property is the lower of adjusted cost (purchase price plus qualified improvements) or fair market value. When the property is later sold, the recognized gain will be the difference between the sales price and conversion tax basis (less depreciation).

  1. If the rental property is not sold but “exchanged” under IRC Section 1031, what is the federal tax treatment?

Answer: If the converted rental property is later sold in a like-kind exchange (1031), the gain would be deferred. If it qualifies for both the 1031 exchange and the converted property qualifies for the IRC Section 121 exclusion (two of five years principal residence gain exclusion rule), a taxpayer may be able to claim both and recognize no taxable gain at the time of the subsequent exchange. 

For an illustration of these two tax laws, see Revenue Procedure 2005-14. This procedure provides guidance on applying the exclusion of gain from the sale or exchange of a principal residence under Section 121 of the Internal Revenue Code and the nonrecognition of gain from the exchange of like-kind property under Section 1031 to a single exchange of property.

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Answered by: Michael A. Gillen, CPA, is director of the tax accounting department at Duane Morris LLP in Philadelphia.

The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.
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