Section 121 Investment Property to Owner Occupancy
I own a property with a relative that we have rented for years. I want to sell my share to him but, want to purchase a personal residence and need all of the proceeds and can not afford the tax ramifications. The home is almost fully depreciated and I would recognize a large capital gain? Can I move into the property for 2 years under section 121 and pay rent to my brother for his share? Would there be any tax ramifications to me if I moved in for the 2 years and then sold and I hope then I can omit my gains? How would I show that on my current tax return? Also what would be the tax implications to him if I am renting at fair value from him, would he still be able to claim the losses? The property is owned 50/50 and we never set up any tax shelters. Thank you. 
Additionally, I do not own any other residences and have lived with my parents for the entire time I have owned this rental. My brother owns and additional rental and a personal residence. We both file Schedule E and have recognized losses on this property since inception. If you have any other advice to help me defer taxes and finally purchase my own personal residence with the proceeds (without negatively effecting my brothers tax consequences, he is intending on financing the purchase from me and then being able to recognize further losses as the current mortgage on this property will be paid in full within 2 years) I would greatly appreciate it.
You and your brother each own half of a rental property that is fully depreciated. You want to sell the property, then use your share of the proceeds to purchase your primary residence.
Your question is what are the tax ramifications, and how do you minimize the tax bite?
First, if you sell the property, each of you will have a taxable gain and each of you will have depreciation recapture to deal with.
If you move into the property for two years, you qualify for the capital gains exclusion on your half of the property. While you are living in the property, you lose your Schedule E tax shelter, and the rent you pay your brother is not deductible. When the property is sold, your brother will have a taxable event for his half of the property, and, you both will pay depreciation recapture anyway.
Your goal seems to be acquiring your own residence, and you want money from your rental property to facilitate your purchase. If this is the case, then why not refinance the rental property, and take cash out tax free? You and your brother will still maintain a profitable rental property, and you get to purchase your primary residence with your half of the refinance proceeds with no adverse tax consequences at all.
If your brother does not mind the tax consequences (you said he owns other rental property), you do not have a taxable event for yourself if you purchase your brother's half of the rental property. Move into the property yourself and establish it as your primary residence. Just refinance the property, then use the cash to buy out your brother. He will have a taxable event, but you don't until you sell the property outright. Your brother can use his tax losses from the other rental property to offset his gains on the sale of this property.
[ Edited by DaveT on Date 01/06/2003 ]
Thanks for the reply. I have a few more questions for you. I read your article on depreciation recapture and was wondering if the property was purchased prior to 1986 would you still be subjected to depreciation recapture? What forms would be required to be filed if we did this?
2>I further talked to my brother and now we are thinking about doing the following:
I am now planning to purchase his 50% share and live there. Are there any consequences to this? I understand I no longer get to take Schedule E but, now I would get RE tax deduction and interest deduction on the new mortgage that I take to finance the purchase from him. I would like to finance 100% of the purchase of his 50% share and I would assume that this is ok too. What forms would I need to file with the IRS when I convert my rental ownership to personal residence? Now if I somewhere down the road (say 3 years) purchase a new primary residence what would happen as I established the 2 year residency requirement? Would I just rollover the basis into the new purchase? I am going to post an additional topic for my brothers consequences. Thanks for all your help.
Q. I read your article on depreciation recapture and was wondering if the property was purchased prior to 1986 would you still be subjected to depreciation recapture? What forms would be required to be filed if we did this?
A. Yes, all depreciation taken is subject to recapture when the property is sold. Between Schedule D and Form 4797 you will report depreciation taken and calculate the tax due on the sale of the property.
Q. I further talked to my brother and now we are thinking about doing the following: I am now planning to purchase his 50% share and live there. Are there any consequences to this?
A. For you no, for your brother yes.
Q. I understand I no longer get to take Schedule E but, now I would get RE tax deduction and interest deduction on the new mortgage that I take to finance the purchase from him. I would like to finance 100% of the purchase of his 50% share and I would assume that this is ok too. What forms would I need to file with the IRS when I convert my rental ownership to personal residence?
A. Consult with your tax advisor for specific details. I believe you report your conversion on Schedule E, and allocate your deductions between rental use and personal use. No Schedule E the next year if you use the property as your primary residence. I am a bit shaky on this answer, so please confirm this approach with your tax preparer.
Q. Now if I somewhere down the road (say 3 years) purchase a new primary residence what would happen as I established the 2 year residency requirement? Would I just rollover the basis into the new purchase?
A. In 1997, changes to the tax code eliminated the rollover replacement rules on the sale of your primary residence, and the $125K one-time capital gains exclusion for sellers aged 55+. Instead a more favorable capital gains exclusion was introduced that gives you the benefit of the capital gains exclusion without requiring rollover of the sale proceeds.
Since, in this example, you have previously used your primary residence as a rental property, depreciation recapture taxes will still be assessed, even though you qualify for the capital gains exclusion.[ Edited by DaveT on Date 01/06/2003 ]