How to Convert an Investment Property into a Personal Residence - Advanced Tax Advisors (2024)

One of the great things about being a real estate investor is that you have the opportunity to convert your rental property to your personal residence. However, there are some tax implications that you need to be aware of before you make the switch. In this blog post, we will outline what you need to know about taxes when you convert your rental property to your personal residence.

Are you thinking about converting your rental property to your personal residence? If so, there are some things you need to know about the tax implications of such a move. Here’s what you need to know about taxes when you convert your rental property to your personal residence.

Capital Gains Tax Implications

The Section 121 Exclusion

One way to avoid paying capital gains tax on the conversion of a rental property to a personal residence is by taking advantage of the Section 121 exclusion. This exclusion allows home sellers to exclude up to $250,000 (or $500,000 for married couples filing jointly) of their capital gains from taxation.

To qualify for the exclusion, you must have owned and lived in the home as your primary residence for at least two of the five years leading up to the sale. Additionally, you can only take advantage of this exclusion once every two years.

If you don’t meet the ownership and occupancy requirements for the Section 121 exclusion, there are still other ways to avoid paying capital gains tax on your rental property conversion.

The 1031 Like-Kind Exchange

Another way to avoid paying taxes on your rental property conversion is by doing a 1031 exchange. Converting 1031 to primary residence allows investors to defer paying taxes on the sale of an investment property by reinvesting the proceeds from that sale into another investment replacement property.

To qualify for a 1031 exchange, both properties must be held for investment purposes (i.e., rentals) and they must be similar in nature (i.e., both single-family homes or both multifamily properties). Additionally, all proceeds from the sale must be reinvested into the new property; if any cash is taken out, it will be subject to taxation.

The 1031 exchange is a complex transaction, so it is important to work with a qualified intermediary who can help ensure that all requirements are met and that the exchange goes smoothly.

Mortgage Interest Deduction Implications

The new tax law has implications for the mortgage interest deduction. If you are thinking of converting your rental property to your personal residence, there are a few things you should know about how the deduction may be affected.

1. The mortgage interest deduction may be less valuable for some taxpayers under the new tax law. The new tax law imposes a $10,000 limit on state and local taxes, which includes property taxes. This means that if you have a high property tax bill, you may not be able to deduct the full amount of your mortgage interest.

2. The mortgage interest deduction may be more valuable for some taxpayers under the new tax law. The new law doubles the standard deduction, which means that fewer taxpayers will itemize their deductions on their tax returns. This could make the mortgage interest deduction more valuable for those who do itemize, because it would represent a larger percentage of their total deductions.

3. The mortgage interest deduction is unchanged under the new tax law. The new law does not make any changes to the mortgage interest deduction, so it remains available to taxpayers who itemize their deductions.

Depreciation Recapture Implications

It is important to be aware of the implications of depreciation recapture.

What is Depreciation Recapture?

Depreciation recapture is the portion of the gain from the sale of your property that is attributable to the depreciation deductions you have taken over the years. When you convert your rental property to your personal residence, the IRS views this as a sale, and therefore, any gain is subject to taxation.

How is Depreciation Recapture Taxed?

Depreciation recapture is taxed at a rate of 25%. This is higher than the regular capital gains taxes rate, which is currently 20%.

What are the Consequences of Depreciation Recapture?

The consequences of depreciation recapture can be significant. Not only will you owe taxes on the gain, but you may also be subject to state and local taxes. In addition, if you have a mortgage on your property, you will need to pay off the loan in full when you sell.

How Can You Avoid Depreciation Recapture?

There are a few ways that you can avoid depreciation recapture. One way is to exchange your property for another rental property. This is known as a 1031 exchange. Another way to avoid depreciation recapture is to wait until you have owned your property for more than 10 years. At that point, any gain will be treated as long-term capital gains and taxed at a lower rate.

Converting your rental property to your personal residence can be a great way to save on taxes. However, there are some tax implications that you need to be aware of before you make the switch. By understanding the tax implications, state and local tax implications, mortgage interest deduction implications, home office deduction implications, and depreciation recapture implications, you can make sure that you do not pay any more in taxes than required.