Your primary or principal residence is one of those areas of tax law that's a little vague. Although the Internal Revenue Service has rules for just about everything, its code does not explicitly define a primary residence for tax purposes. One thing is clear, however – you must live in the home at some point.
Primary Residence Rules
If you want to declare that your rental property is your primary home, you'll have to provide the IRS with some proof if it questions your position. Acceptable proof includes commonsense factors that apply to anyone who lives in a certain residence for an extended period of time. You receive your important mail there. You're registered to vote at that address. The address appears on your driver's license. Renting the place out for a period of time is not a barrier in most tax issues, but you must have lived there yourself at some point as well.
Income Tax Deductions
If you do decide to move in to a property you've maintained as an investment, you'll lose some income tax deductions. During the period of time that it's a rental, you can claim expenses such as repairs, maintenance, insurance, depreciation – even the cost of the ad you put in the newspaper to find a tenant. When you convert the property to your primary residence, you can only deduct your property taxes and mortgage interest.
The Taxpayer Relief Act
If you've been investing in real estate, capital gains issues might be even more important to you than itemized tax deductions. If you convert your rental property to your primary residence, and if you live there for two out of five years, you can exclude up to $250,000 in profit from capital gains tax if you sell the property. If you’re married, this exclusion increases to $500,000. The two years don't have to be consecutive. There's a catch, however. To take advantage of this full exclusion under the Taxpayer Relief Act of 1997, you must live in your property first, then rent it out. If you do it the other way around, some limitations apply.
The Housing Assistance Act
If you rent your property first, then move in and declare it as your personal residence, the Housing Assistance Act of 2008 dictates how much you'll have to pay in capital gains if you eventually sell it. This involves a little math. You must divide the number of years you rented the residence by the number of years you owned it. If you owned the house for five years and rented it out for the first three, this means you treated it as an investment 60 percent of the time. Therefore, you're limited to an exclusion equal to 40 percent of your profit, or the percentage of time you treated the property as your primary residence. For example, if you realize a $200,000 capital gain, instead of being able to exclude the entire amount from capital gains tax, you can exclude only 40 percent or $80,000.
The Housing Assistance Act is not retroactive to a time before it was passed, so you might be able to dodge its ramifications if you rented your property before you converted it to your primary residence. If you rented the house in 2008 or before, the Act doesn't apply to those years, so you can claim the full exclusion under the terms of the Taxpayer Relief Act.
- Iowa Equity Exchange: Converting Investment Property to Principal Residence? New Limits on Gain Exclusion!
- First American Exchange Company: Converting Investment Property to Your Primary Residence
- Realty Times: What's Your Principal Residence? Tax Experts Not Always Certain
- IRS: Itemized Deductions, Standard Deductions
- Nolo: Top Ten Tax Deductions for Landlords
- Internal Revenue Service. "Publication 523: Selling Your Home," Page 3. Accessed Jan. 19, 2020.
- Internal Revenue Service. "Publication 523: Selling Your Home," Pages 3-4. Accessed Jan. 19, 2020.
- Internal Revenue Service. "Publication 527 (2018), Residential Rental Property." Accessed Jan. 30, 2020.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.