Using Capital Gains Exclusion Rules to Your Advantage

Make the capital gains tax on the sale of your vacation home or rental property disappear by learning how to play by the rules.

This article will show you how to convert your rental property or vacation home into a primary residence prior to the sale to make those pesky capital gains disappear. It is a little complicated, but altogether possible and legal.

The loophole is this. You are allowed to sell a primary residence once every two years and exclude up to $250,000 (or $500,000 for a married couple) of the gain of the sale. It is a new rule. The old rule of "once in a lifetime" or being a certain age no longer apply. This is a new capital gains rule and it can work to your advantage.

This is how it works: 1. You have to have owned the property for at least two years. 2. The property must pass the primary residence test. 3. You can't sell more than one primary residence in any two-year period.

If you meet those criteria, you can take the exclusion of your capital gains (up to the limits described above). It can really pay off to have some patience, know the rules and take advantage of this exclusion.

If you are lucky enough to own two properties and want to sell both of them, it may be worth your while to take your time. One strategy to save the most is to sell your primary residence first. Move into the second property for a period of two years and sell it as your primary residence. This allows you to exclude gains from both sales. Of course, it does mean a two-year waiting period between sales and before you get the money from the second sale.

The good news with a rental conversion is that by converting the second property into a primary residence you can ignore any of the appreciation the rental unit may have realized as a rental unit. The two-year waiting period has changed that property's status into a primary residence that does qualify for the exclusion.

One caveat does remain, however. You may be subject to depreciation on the property. Any depreciation taken after May 6, 1997 will be subject to recapture and tax. Depreciation taken before that date is forgiven and available for the gain exclusion.

Now what about when you own two properties and have to sell both? There is a way to do this and qualify for the gain. You just have to know the rules, and play by them.

Here's how it works. Say you have a primary residence and a rental property. The primary residence is in the country and the rental property is in the city. You have lived in the primary residence for a few years when you decide that you want to live closer to work. You rent out your primary residence and move into the place in the city. After two-and-a-half years you get a promotion to a new city and need to sell both places.

Good news for you is that both properties now qualify for the exclusion. Why? Because the rule states that you have to have lived in the property as a primary residence for at least two years within the five-year period leading up to the sale of the property. Since you lived in the house in the country, then moved to the city for a period of two-and-a-half years, you qualify for primary residence on both properties and can sell both without incurring capital gains taxes.

These are just a couple of ways you can get use the capital gains exclusion rules to your advantage. There are a number of other ways available if you take the time to learn the rules and put them to practice. Talk to your financial advisor for more ideas about saving on capital gains.

Source: Based on information from The Motley Fool.