If you decide to move into a property you initially purchased as an investment, you'll save yourself a lot of tax dollars if you ultimately decide to sell it. Selling an investment property puts you at risk for having to pay capital gains tax on your profit. You bought it as an investment and it did what it was supposed to do; it made you money. But the rules change if you use the property as your primary residence.
The passage of the Taxpayer Relief Act in 1997 changed the complexion of the capital gains you can realize without tax consequences on a home. As of publication, if you live in a home for at least two out of five years that you own it, you can reap a profit of up to $250,000 before you have to pay capital gains tax. This increases to $500,000 if you're married and file jointly. The two-year period does not have to be consecutive. For example, you might purchase the home, live in it for a year, rent it out for two years, then move back in for a year. If you then decide to move out again because you've found a more appropriate home, you can either rent the property again, or simply let it sit empty for a year and hopefully appreciate. At the end of five years, you can sell it without paying capital gains on $250,000 to $500,000 of your profits, depending on your marital status.
You can only sell a property and claim the exclusion from capital gains tax once every two years. If you have more than one investment property and you move in and out of them to take advantage of the terms of the Taxpayer Relief Act, you must wait two years between the sale of each of them to exclude your profits on each. This rule also applies if you're married now, but one of you sold a home and excluded the profits from capital gains prior to tying the knot. It doesn't matter if you were single at the time; the sale still counts toward the two-year period and you'd have to wait two years from the date of that sale to claim the full $500,000 tax break available to married couples on the sale of your next property.
If you sell a property for a loss, the IRS doesn't care if you lived in it for two years or not. You can still claim the loss on your tax return, subject to certain restrictions. First the loss offsets any gains you realized from other investment property you sold, or primary residence profits that exceed the $250,000 or $500,000 limit. Beyond that, if there's any loss left over, you can deduct up to $3,000 from the remainder of your income. If you still have some loss left over, you can carry it forward to the next tax year.
How to File
If you realize less than a $250,000 profit, or $500,000 if you're married, and if you meet the residency requirements, it's not necessary to report the funds on your return. Otherwise, you would need to complete Schedule D and attach it to your tax return. The same applies if you show a loss.
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