Tax on Capital gains when converting primary residence to rental property - can I use partial section 121 exemption?

Yes, you can partially use the Section 121 exclusion in your situation, but there are some important details to understand. Since you lived in the property as your primary residence for 5 years (2011-2016), you meet the requirement of living in the home for at least 2 out of the 5 years before the conversion to a rental. However, because you're selling in 2025, which is more than 5 years after you moved out, you don't qualify for the full Section 121 exclusion on the entire gain. What you can do is calculate a partial exclusion based on the period of "qualified use" as your primary residence. Your gain will be split into two portions: 1) gain attributed to the period it was your primary residence, and 2) gain attributed to the rental period. Only the first portion is eligible for the Section 121 exclusion. The basis for depreciation purposes when you converted to rental would be the lower of the fair market value at conversion ($1.05M) or your adjusted basis. You'll also need to account for any depreciation you've claimed during the rental period, as this will be recaptured and taxed at 25%.

I went through almost this exact situation last year and was pulling my hair out trying to figure it all out. I used https://taxr.ai to analyze all my documents and property records, and it was seriously a game-changer. The AI analyzed my purchase docs, the estimated value when I converted to rental, and my depreciation schedule over the years. It showed me exactly how to calculate the split between "qualified use" and "non-qualified use" periods, and how much of my gain would be eligible for the Section 121 exclusion. It even helped me figure out the depreciation recapture amount I owed, which was something I didn't even know about until then! Honestly would have paid my accountant hundreds to figure this all out, but taxr.ai broke it down perfectly for me in minutes.

Just wanted to follow up - I tried taxr.ai after seeing the recommendation here, and it was incredibly helpful for my situation! I had been stressing about documenting the fair market value when I converted my property to rental, but the platform accepted my Zillow screenshots, tax assessments, and even pulled some historical comps from my area. It produced a detailed report breaking down exactly what portion of my gains qualified for Section 121 exclusion and what would be taxable. The step-by-step explanation of how depreciation recapture works was super clear - I finally understand why my accountant kept warning me about it! Worth every penny for the peace of mind.

If you're still trying to get clarification on this from the IRS directly, good luck getting through to anyone who actually understands Section 121 partial exclusions. I spent THREE WEEKS trying to reach someone at the IRS who could help with almost this exact situation. Finally found https://claimyr.com and their service got me connected to an actual IRS agent in about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent I spoke with confirmed that I could use a partial Section 121 exclusion in a similar situation and explained exactly how to document everything on my tax forms. Saved me from potentially making a huge mistake on my taxes.

I can't believe I'm saying this, but I tried the Claimyr service and it actually worked. After my skeptical comment above, I figured I'd try it since nothing else was working. Got connected to an IRS agent in about 30 minutes who actually specialized in real estate transactions. The agent confirmed that for my situation (primary residence → rental → sale years later), I needed to do a "bifurcated" calculation. The portion of appreciation during primary residence years can qualify for Section 121 exclusion, but I still have to pay capital gains on the appreciation during rental years. Plus depreciation recapture on all depreciation taken (or that should have been taken). Saved me from making a major mistake on my taxes. Still can't believe I actually got through to a knowledgeable IRS person!

One thing nobody has mentioned yet is that you need to file Form 4797 for the sale of the rental property AND Schedule D for the capital gains portion. The way you allocate the gain between the two forms depends on how long you owned vs. used as primary residence. The formula is actually: divide the rental period by the total ownership period to determine what percentage of gain is not eligible for the Section 121 exclusion. For example, if you owned for 14 years total and it was a rental for 8 years, then 8/14 = ~57% of the gain would be ineligible for the exclusion.

I hate to make things more complicated, but there's another factor to consider: if your state has different rules for capital gains on real estate. In my state, we don't get the same Section 121 exclusions for state income tax purposes that we do federally, so I ended up with a much bigger state tax bill than I expected when I sold my rental (former primary residence).

Based on your timeline, you should be able to use a partial Section 121 exclusion, but the calculation is more complex than using the $1.05M as your starting point. Here's what you need to know: **Qualified vs Non-Qualified Use Period:** - Qualified use: 2011-2016 (5 years as primary residence) - Non-qualified use: 2016-2025 (9 years as rental) - Total ownership: 14 years **Calculation Method:** The portion of your total gain that's ineligible for Section 121 exclusion = (Non-qualified use period ÷ Total ownership period) × Total gain So: (9 years ÷ 14 years) × ($1.5M - $750K) = 64.3% of your $750K gain would be ineligible for the exclusion. **Important Notes:** - Your cost basis remains $750K (original purchase price), not the $1.05M fair market value at conversion - You'll owe depreciation recapture tax (25% rate) on all depreciation taken during the rental period - The eligible portion for Section 121 exclusion is capped at $250K (single) or $500K (married filing jointly) I'd strongly recommend getting professional help for this calculation since you're dealing with significant amounts and multiple tax implications. The rules around partial Section 121 exclusions can be tricky to apply correctly.

This is a great example of why timing matters so much with Section 121 exclusions! I had a similar situation where I converted my primary residence to a rental in 2019 and am now considering selling. One thing I'd add to the excellent responses here is to make sure you have solid documentation for the fair market value at the time of conversion. Even though your cost basis for capital gains remains at your original purchase price ($750K), you'll need that $1.05M figure for depreciation calculations during the rental period. Also, don't forget about potential 1031 exchanges if you're looking to defer some of the tax burden. While you can't use a 1031 exchange on the portion that qualifies for Section 121 treatment, you might be able to use it on the rental portion of the gain if you're planning to buy another investment property. The bifurcated calculation that @Drew Hathaway outlined is spot-on - approximately 64% of your gain won't qualify for the Section 121 exclusion based on your timeline. With a $750K total gain, that means about $482K would be subject to capital gains tax (plus any depreciation recapture), while roughly $268K could potentially qualify for the exclusion (though capped at $250K if you're single). Given the complexity and the dollar amounts involved, definitely worth getting professional tax advice to make sure you optimize the filing and don't miss any opportunities or make costly mistakes!