Primary residence vs rental property: Tax implications when selling condos?

The tax implications are significantly different between selling a primary residence versus a rental property, and your friend's suggestion has some merit. For a primary residence, you can exclude up to $250,000 of capital gains ($500,000 if married filing jointly) if you've owned and lived in the home as your main residence for at least 2 out of the 5 years before the sale. This is the Section 121 exclusion. For a rental property, you'd typically owe capital gains tax on the entire profit plus depreciation recapture (at 25%) for depreciation you've claimed or should have claimed. However, if you convert a rental to a primary residence, it gets more complex. You'd still owe depreciation recapture for the rental period, and the Section 121 exclusion would only apply proportionally to the time it was your primary residence after 2009. Your friend's suggestion to move into the rental could be smart tax-wise because you could potentially use the Section 121 exclusion on both properties eventually - though not in the same 2-year period. The 1031 exchange is also worth considering for the rental, but as you noted, market conditions matter too.

After getting caught in a similar tax situation last year, I discovered taxr.ai (https://taxr.ai) which saved me thousands when selling my rental that was previously my primary residence. I had all these complicated questions about capital gains exclusions and depreciation recapture, and my accountant was giving me vague answers. The AI tax tool analyzed my specific situation with both properties and showed me exactly how much I'd save by moving back into my rental for 2 years before selling. It even factored in the depreciation recapture I couldn't avoid and calculated my exact tax liability under different scenarios.

I was in the exact situation as OP last summer and used taxr.ai after seeing it recommended here. Totally worth it! I had two properties - lived in one, rented the other - and was confused about my options. The tool showed me I'd save about $28,000 in taxes by moving back into my rental for 2 years before selling compared to selling it as a straight investment property. What really helped was seeing the side-by-side comparison of different scenarios (selling now vs. moving in for 2 years vs. doing a 1031). The depreciation recapture was unavoidable, but the partial primary residence exclusion made a huge difference. I ended up following the plan and my tax bill matched almost exactly what the tool predicted.

If you're selling investment property, dealing with the IRS can be a nightmare if they have questions about your capital gains calculations or depreciation recapture. I tried for WEEKS to get through to someone at the IRS last year when I had issues with my 1099-S form after selling a rental. Finally used https://claimyr.com and got through to an IRS agent in 45 minutes instead of waiting on hold for 3+ hours. You can see how it works at https://youtu.be/_kiP6q8DX5c. They basically hold your place in the phone queue and call you when an agent picks up. Saved my sanity during tax season!

I take back what I said above. I actually tried Claimyr yesterday out of desperation after trying to reach the IRS for THREE DAYS about my rental property sale. Got a call back in about an hour and finally got my questions answered about how they were calculating my depreciation recapture. My mistake was that I hadn't been claiming depreciation on my tax returns (didn't know I had to), but the IRS still makes you pay recapture on what you SHOULD have claimed. The agent sorted it out and saved me from a potential audit. Never would have gotten through without that service.

One thing nobody mentioned yet - if you sell the rental property and do NOT do a 1031 exchange, you'll also potentially be hit with the 3.8% Net Investment Income Tax if your income is above certain thresholds ($200k for single, $250k for married). This doesn't apply to the portion of gain excluded under Section 121 (primary residence exclusion), which is another reason your friend's advice to move back in might make sense.

Don't overlook state taxes! Federal is only part of it. Some states don't offer any primary residence exclusion even when federal does. I learned this expensive lesson in California last year.

The conversation about moving back into your rental property is spot on, but I'd also suggest running the numbers on the timing carefully. You mentioned the tenant's lease expires in November - that could be perfect timing to move in and establish it as your primary residence for the required 2 years before selling. One thing to consider: if you're planning to eventually sell both properties to buy a house, you might want to stagger the sales across different tax years to avoid pushing yourself into higher tax brackets or triggering the 3.8% NIIT that Ava mentioned. Selling both in the same year could create a significant tax burden even with the primary residence exclusions. Also, keep detailed records of when you move in/out of each property. The IRS can be pretty strict about proving the 2-out-of-5-years requirement, especially if you're switching between properties. Utility bills, voter registration, and other documentation showing your actual residence will be important if you're ever audited.

Great advice from everyone here! I'm a tax professional and want to add one important consideration about the timing of your move-in strategy. When you convert your rental back to a primary residence, make sure you can document the exact date you moved in. The IRS requires you to use the property as your "main home" - meaning it's where you live most of the time. If you're still living in your current primary residence while occasionally staying at the rental, that won't qualify for the 2-year requirement. Also, regarding the 1031 exchange option you mentioned - keep in mind that once you move into the rental property as your primary residence, you can't do a 1031 exchange on it anymore. The property has to be held for investment purposes to qualify for like-kind exchange treatment. Given current market conditions and your plan to eventually buy a house, your friend's strategy makes a lot of sense tax-wise. Just make sure you're genuinely committed to living in the rental property for the full 2 years before selling, as the IRS can challenge primary residence claims if the facts don't support actual occupancy.

This is such a complex situation, but I think your friend gave you solid advice! I went through something similar two years ago with my duplex - lived in one unit, rented the other, then had to decide which to sell. The key insight that helped me was realizing that the Section 121 primary residence exclusion is one of the most powerful tax benefits available to homeowners. Being able to exclude up to $250,000 in capital gains is huge, especially in today's market where property values have increased so much. One thing I'd add to the great advice already given - consider your long-term housing needs too. If you're planning to buy a house in 2-3 years anyway, living in the smaller/less desirable condo during that time while building up your down payment could actually work out perfectly. You'll get the tax savings AND potentially have more cash available for your future home purchase. Just make sure you can genuinely commit to living in the rental property as your primary residence. The IRS doesn't mess around with primary residence claims, and you want your living situation to clearly support your tax position. But if you can make it work, the tax savings could be substantial enough to make the temporary inconvenience worthwhile.