Capital Gains exclusion from sale of residence

[ej401]

NY co-op apartment owned and used as second-home from 2007; rented in July 2011.Plan to make it primary residence in July 2014 when rental ends. Will rent current primary residence, NJ condo, to enable the move to NY. Will capital gains exclusion be applicable after sale of NY apartment in July 2016?
Thank you.

[mwcpa]

It will qualify in 2016 for a partial exclusion, there is a tainted period of ownership when the property was not used as a primary residence that will lead to some of any gain always being not subject to the exclusion.

The non qualified period begins January 1, 2009 and goes until July 2014.  That is 66 months.  Total ownership would be from 2007, let's say for argument sake, it was purchased in July 2007 until it was sold in July 2016, that would be 108 months.

Therefore, 66 out of 108 months is not qualified.  The exclusion of 250k is limited by the non qualified use period.

See publication 523 published by irs for more details.  This law was put into place during the Bush years to help pay for the 15% tax rate on dividends and capital gains.

In addition the depreciation that was allowed or allowable is subject to tax.

All of this assumes there is a gain on the sale in 2016.

Here is a worksheet contained in the IRS publication referred to earlier.

Gain or (Loss) on Sale, approximate, based on the facts noted above (as days) but assumes an overall gain of 200,000 and depreciation allowed or allowable of 10,000

5. Gain or (loss) on the sale. Subtract line 4 from line 3. If this is a loss, stop here	200,000
6. Enter any depreciation allowed or allowable on the property for periods after May 6, 1997. If none, enter -0-	10,000
7. Subtract line 6 from line 5. If the result is less than zero, enter -0-	190,000
8. Aggregate number of days of nonqualified use after 2008. If none, enter -0-. If line 8 is equal to zero, skip to line 12 and enter the amount from line 7 on line 12	1,980
9. Number of days taxpayer owned the property	3,240
10. Divide the amount on line 8 by the amount on line 9. Enter the result as a decimal (rounded to at least 3 places). But do not enter an amount greater than 1.00	0.611
11. Gain allocated to nonqualified use. (Line 7 multiplied by line 10)	116,111
12. Gain eligible for exclusion. Subtract line 11 from line 7	73,889
13. If you qualify to exclude gain on the sale, enter your maximum exclusion (see Maximum Exclusion ).  If you qualify for a reduced maximum exclusion, enter the amount from Worksheet 3, line 7. If you do not qualify to exclude gain, enter -0-	250,000
14. Exclusion. Enter the smaller of line 12 or line 13	73,889
15. Taxable gain. Subtract line 14 from line 5. Report your taxable gain as described under Reporting the Sale . If the amount on line 6 is more than zero, complete line 16	126,111
16. Enter the smaller of line 6 or line 15. Enter this amount on line 12 of the Unrecaptured Section 1250 Gain Worksheet in the instructions for Schedule D (Form 1040)	10,000

[ej401]

Thanks so much MW!  You are the Best!!

I was trying to see if better to sell now than in 2016 with 2 years of primary residence.  I was not aware of this exclusion proration for unqualified use.
 
The worksheet is quite clear.  With a projected gain of 200,000 and 10,000 depreciation, with ownership from Jan 1, 1997 to July 1, 2016, I think it would look like:

* Non qualified use 1/1/2009 to 7/1/2014: 66 months (1980 days)
* Ownership 1/1/1997 to 7/1/2016: 234 months (7020 days)
* Gain for Non-qualified use = 53,580 (190,000 x 1980/7020)
* Allowed exclusion: 136,420 (190,000 minus 53,580)
* Taxable gain: 63,580 (200,000 minus 136,420)

And of course in addition, the 25% tax on 10,000 depreciation recapture.

Would you kindly tell me if my rough calculation is correct?
Thanks again and have a great weekend. 

[mwcpa]

Ej... Your rough looks close..... The actual calc would be subject to actual days.... But having more time in the home would lower the taxable gain (going past the 2016 date noted).

the non qualified use rule comes as a shocker to many.... And it is missed by many as well....

[ej401]

MW - THANK YOU!!!

The qualified use rule is indeed quite a shocker.  And something else I cannot quite comprehend.  Depreciation decreases the basis, therefore increases taxable amount; then depreciation is taxed separately at even the higher rate of 25%.  I am sure I am missing something - but this 'double treatment' is a puzzlement. Of course, the depreciation, when taken, diminished the taxable income - but somehow it does not seem to 'compute'. Kindly elucidate.

Out of 19.5 years of ownership, the 3 years rental depreciation looks like a very negative tax impact. Almost negates the rental income, which is not much after high monthly maintenance fees on NYC co-ops. 

MW - you are truly very kind to help everyone with your valuable time and expertise!                                    

[mwcpa]

Depreciation does reduce basis, and the charge is a tax deduction that offsets the rental income. This expense can be worth as much as 39.6% (the highest tax rate) + lowers the new "Medicare" tax on net investment income (another 3.8%).

There is no double taxation....

If you paid 100 for a depreciable asset

Was allowed depreciation of 10 (39.6% tax benefit potential + potential savings on the 3.8% net investment income tax)

Your basis is 90.

You sell the property for 200

Your gain is 110.

The 110 gain is "taxed" as follows:

10 (the allowed or allowable depreciation) @25%

100 (the long term gain) @ 15/20%

Both are subject to the 3.8% net investment income tax.

Hope this clarifies

[ej401]

    "The 110 gain is "taxed" as follows:
    10 (the allowed or allowable depreciation) @25%
    100 (the long term gain) @ 15/20%
    Both are subject to the 3.8% net investment income tax."

Thank you MW - I think I understand.  But being a visual person, I think what I am missing is where (form and line) does the 25% tax on depreciation show? I see in form 4797 the depreciation as a reduction in basis; but where is the depreciation tax @25% and long term gain @ 15/20% differentiated, or calculated separately, or accounted for?  Probably a very naive question - I am sorry.

Thanks so much again for your time. 

[mwcpa]

The schedule D instructions include the worksheets and schedules to help compute the multitude of tax rates on capital gains.... www.irs.gov/pub/irs-pdf/i1040sd.pdf (page 14 and 15 of the publication cover your situation of the potential of the 25% rate).... Congress made none of this easy....

[ej401]

Good morning MW and Thank you! 
You are truly amazing - you are always there to help, to teach, to enlighten everyone!  I am in pre-k where taxation is concerned. It is just something that fascinates me - and reading you here in Tax Talk is like taking free e-courses!

Indeed Congress did not make it easy- there must be some unbelievably smart wordsmiths there. IMHO - seems like tax language is written to obfuscate on purpose. Methinks legalese is a bit easier to comprehend than 'tax-ese'.

As you clearly explained, depreciation recapture is not double taxation - although it may look like it.
How about if apartment is sold now instead of trying to get some cap gains exclusion by making it primary residence until July 2016. The gain of approx 220K will be the only income source for 2014.  So - this 200K will be taxed as ordinary income in addition to cap gains tax, in addition to NIIT? My half-heimer's brain thinks this is multiple taxation.  Please - what am I missing?

Thanks again.  Have a wonderful week! 
 

[mwcpa]

The sale of the real estate today would result in a long term capital gain... You have held the property for more than a year.... You would be subject to the 15/20/25 tax rates.

[ej401]

Thanks so much!