Tax implications when selling a former primary residence turned rental property?

Wait I'm confused. So if I lived in my house for 10 years, then rented it out for 3, then sold it, would I still get the whole exclusion? Or just part of it? And do I have to buy another house right away to avoid taxes?

In your example, you would qualify for the full exclusion since you used it as your primary residence for at least 2 out of the 5 years before the sale. However, you would still face depreciation recapture on any depreciation taken during those 3 rental years. You don't have to buy another house right away to claim the Section 121 exclusion. That's a common misconception. The Section 121 exclusion is different from a 1031 exchange, which allows deferring taxes when selling an investment property and buying another investment property.

How does that work exactly? Do you just upload your documents and it figures everything out? I'm in a similar situation but I've owned my house for 15+ years and have been renting it out the last 3. Trying to figure out if I should sell this year or wait.

Does it handle situations where you've done improvements to the property? I've added a new roof, HVAC, and did some bathroom remodeling while it was a rental. I'm worried I'll mess up what gets added to the basis.

Yes, you just upload your closing documents from when you bought the house, any documentation of improvements, and information about when you converted it to a rental. It then gives you a complete analysis of your tax situation including adjusted basis calculations. For property improvements, it absolutely handles those. It actually helped me identify several improvements I had made that I could add to my basis, which reduced my gain. It walks you through categorizing which improvements are repairs (immediately deductible) versus capital improvements (added to basis).

How do they actually get you through? I've called the IRS like 5 times this year and either get disconnected or told the wait time is over 2 hours. Do they have some special number or something?

Sounds like a scam tbh. Nobody can magically get through to the IRS faster. They probably just have someone pretending to be an IRS agent. I'd be careful giving them any personal info.

They don't use a special number - they use technology that continuously redials and navigates the IRS phone tree until they get through, then they transfer the call to you. It's basically doing what you would do if you had unlimited time and patience. No, it's definitely not a scam. They never ask for your personal information and don't pretend to be IRS agents. They simply connect you with the actual IRS. They're just solving the problem of getting through the phone system. When you get the call, you're speaking directly with a real IRS employee, not someone from Claimyr.

Don't you also need to use a qualified intermediary for a 1031? I heard you can't just sell and then buy - the money has to go through some special third party or something.

Yes, absolutely correct. You need a Qualified Intermediary (QI) to handle the funds - you can't touch the money yourself or it disqualifies the exchange. The QI holds the proceeds from your sale and then uses those funds to purchase the replacement property. This is called the "no touch" rule and it's one of the most common mistakes people make with 1031 exchanges. Once you touch the proceeds, even for a day, the exchange is invalidated and the entire gain becomes taxable.

Good point. I'm in Massachusetts and they basically follow the federal rules, but I know some states have their own thing going on. Has anyone dealt with this in New York? Moving there soon and might sell my current place after renting it for a while.

I'd actually considered doing something like that! But wouldn't I lose rental income during those months? Did you find that the tax savings outweighed the lost rental income in your case?

In my case, yes, the tax savings significantly outweighed the lost rental income. I was looking at about $180,000 in capital gains, so the tax savings was approximately $27,000 (15% capital gains rate). My monthly rental income was around $2,000, so for 6 months that's $12,000 in lost income. Even after accounting for moving expenses, it was worth it financially. Plus, it gave me time to do some cosmetic updates that helped the house sell for more. Just make sure you're genuinely using it as your primary residence - the IRS looks at factors like where you get mail, where you're registered to vote, etc.

This is such great advice about record keeping! I'm just starting to think about converting my primary residence to a rental and I'm already feeling overwhelmed by all the documentation I'll need to track. Do you have any recommendations for organizing all these records? Like should I be using spreadsheets or is there specific software that helps with tracking basis adjustments and depreciation over time? I want to make sure I'm set up properly from day one rather than scrambling to reconstruct everything years later when I sell.

For organizing records, I'd recommend a combination approach. I use a simple spreadsheet to track the big picture items (purchase price, major improvements, depreciation schedule) but also maintain a dedicated folder (digital and physical) for all supporting documents. The key categories I track are: 1) Original purchase documents, 2) Capital improvements (anything that adds value or extends useful life), 3) Repairs and maintenance (immediately deductible), 4) Conversion documentation (fair market value when converted to rental), and 5) Annual depreciation schedules. For software, QuickBooks Self-Employed has been helpful for tracking rental income/expenses, and it integrates well with tax prep. But honestly, a well-organized spreadsheet with scanned receipts in cloud storage has worked just fine for me. The most important thing is consistency - set up your system now and stick with it from day one. Also, take photos of any improvements as you make them. I wish I had done this more systematically. When the IRS auditor asked about a bathroom renovation from 2018, having before/after photos really helped substantiate that it was a capital improvement rather than just repairs.

This is incredibly helpful information, thank you! The non-qualified use period calculation is something I hadn't fully understood before. Just to make sure I'm following correctly - if I lived in my house for 10 years, then rent it out for 2 years before selling, would I still get the full Section 121 exclusion since I meet the 2-out-of-5-years test? Or would part of my gain be allocated to the non-qualified use period and lose the exclusion benefit? Also, the point about "allowable" depreciation is eye-opening. I had no idea you could owe recapture tax on depreciation you didn't actually claim. That seems like it could really catch people off guard if they weren't properly depreciating their rental from day one.

@Grace Thomas In your scenario 10 (years primary residence, 2 years rental ,)you would still qualify for the Section 121 exclusion since you meet the 2-out-of-5-years test. However, under the non-qualified use rules, you d'need to allocate your total gain between the qualified period 10 (years and) non-qualified period 2 (years .)So if your total gain was $120,000, roughly $20,000 would be allocated to the non-qualified use period 2/12 (of the total and) wouldn t'be eligible for the Section 121 exclusion. The remaining $100,000 allocated to qualified use could be excluded up (to the $250K/$500K limits .)The depreciation recapture issue is definitely a gotcha that trips up a lot of people. The IRS reasoning is that you received a tax benefit by being allowed "to" depreciate, whether you actually took it or not. So even if you forgot to claim $10,000 in depreciation over two years, you d'still owe the 25% recapture tax on that $10,000 when you sell. It s'worth filing amended returns to claim any missed depreciation since you re'going to pay the recapture tax anyway!

Great questions! For multiple conversions like your example, the IRS looks at the aggregate periods of qualified vs non-qualified use. So in your scenario (5 years primary, 2 years rental, 1 year primary, 1 year rental), you'd have 6 years of qualified use and 3 years of non-qualified use out of 9 total years. The gain allocation would be based on those ratios. However, there's an important exception - any non-qualified use periods that occur BEFORE the last period of qualified use don't count against you. So if you moved back in for that 1 year, the initial 2-year rental period might not reduce your exclusion, but the final 1-year rental period would. Regarding proving primary residence, the IRS uses a "facts and circumstances" test. Key factors include where you sleep most nights, where your personal belongings are stored, voter registration, driver's license address, bank statements, utility bills, and where your immediate family lives. You don't need ALL of these, but having multiple indicators helps establish genuine intent rather than just tax planning. The timing strategy can work, but make sure it's legitimate - the IRS is suspicious of obvious temporary moves solely for tax purposes. Document everything and be prepared to show genuine residential use!