Capital Gains Rules Regarding Residence Exclusions
Capital gains tax can be a significant burden when selling an investment property. Federal capital gains tax rates are 15 percent and set to go up to 20 percent or higher when the Bush era tax cuts expire at the end of 2010. However, some properties can be exempt from capital gains tax, depending on how they were held and how much appreciation they have experienced.
Primary Residence Exclusion
The only properties that can be excluded from capital gains tax consideration are primary residences and then, in some cases, only partially. There is a primary residence exemption of up to $250,000 for an individual and $500,000 for a couple filing jointly. If your capital gain on the sale exceeds those amounts, you will still have to pay the tax on the amount that remains after using the exclusion.
In order to claim this exemption, you must have lived in the property as your primary residence for two out of the last five years. Additionally, the exclusion can only be used once every two years, so provided you can show that the home was your primary residence for the two-year period, you have not used the exclusion and your capital gain did not exceed $250,000 for an individual or $500,000 for a married couple filing jointly, then you won't owe any capital gains tax on your sale.
As you can see, it is possible to use this option every two years; and as such, you could convert a rental property to your primary residence for two years in order to avoid paying capital gains tax. Or, you could convert a primary residence you've lived in for at least two years into a rental; and as long as you sell it within the five-year time period, you can still avoid paying any capital gains tax.
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