Using the Tax-Free Exclusion for Rental & Business Properties

One of the most powerful ways to minimise your tax bill is by ensuring that your properties qualify for the tax-free exclusion.  Used correctly, this exclusion can mean that you pay very little tax on gains of up to $500,000 – as long as the property in question has been your main residence for at least 2 in the 5 years prior to sale.

This generous exclusion can even be applied to your rental properties or if you use part of the property for your business. However, certain criteria must be met in order for such properties to qualify for the tax-free exclusion.

Profits from rental properties can be sheltered very effectively by the tax-free exclusion using one of the following methods:

Firstly, you could declare an existing rental property as your main residence. You must make sure that you pass the required ownership and use tests by occupying the property as your main residence for at least two years.

Alternatively, you could move out of your current home and rent it out. As long as the property is sold within three years, you will pass the required ownership and use tests.

Please note that if the property is not sold within the first three years, it would be impossible to say that you have lived in it for two out of the last five years and you would fail the ownership and use tests.

In summary, you will be entitled to the tax-free exclusion if you either move in to an existing rental property and make it your main residence or if you convert your existing main residence into a rental property - as long as you pass the required ownership and use tests.

Using the above methods to qualify for the tax-free exclusion, there are a few tax issues to consider. You may have to use Form 4797 instead of Schedule D when reporting the sale of the property. Also, when calculating how much of your gain is tax-free you will need to take depreciation into account.

Depreciation deductions can be claimed when renting out your property. They may also be claimed when using part of your home for business purposes, which we will look at in more detail later.

Depreciation must be recaptured and taxed when you finally come to sell the property.

For example, if you sell a rental property that used to be your main residence (qualifying it for the tax-free exclusion) and make a gain of $120,000, even though the gain is below the $250,000 tax-free exclusion threshold not all of it will be completely tax exempt. If, whilst the property was rented out, you claimed depreciation deductions of $8,000 then your tax calculation would be:

            $120,000 gain - $8,000 depreciation recaptured = $112,000 tax-free

This means your taxable gain on the property would be $8,000. Even if you made no depreciation deductions previously, you will still need to take in to account and deduct any depreciation you were entitled to.

Only depreciation deductions for periods after May 6th 1997 have to be recaptured – any amounts before this date wont be taken into account.

Many people use part of their home for business purposes. As long as you can pass the ownership and use tests, you can still claim the tax-free exclusion when you sell the property.

It is important to note that if you use a separate part of your home as a business property, this will then be treated as two separate properties and taxed accordingly. Sale of the business part of the property must be reported on Form 4797.

Assuming that part of your home is used for business purposes without using a separate part of the property, you need only report this on the Schedule D form. In conclusion, the tax-free exclusion is a powerful, flexible way to minimise your tax liability. Whether you have a rental property or business property, as long as you make sure your pass the required ownership and use tests and remember to recapture any depreciation deductions, you could be facing a much smaller tax bill than you expected when you sell the property.