Investment Property Converted to a Primary Residence

Investment Property Converted to a Primary Residence

The Investment Property Converted to a Primary Residence One question that always comes up is whether a taxpayer can “convert” or “recharacterize” an investment property to a primary residence and thereby qualify for the primary residence exemption.

The answer is clearly yes. But the owner and the property will have to meet all of the primary residence exclusion tests; this means the taxpayer will actually
have to use the property as his or her primary residence for the two-year use period. Sometimes that is simply too high a price to pay to qualify the property for the exemption, but sometimes it is a smart move.

Example:
Jack and Barbara, who are both retired, live in a suburb of San Francisco but are planning a move to Palm Springs. They own a triplex within the San Francisco city limits that was left to them many years ago by Barbara’s mother and has been fully depreciated since 1995. The triplex was originally built as a single-family house but had been converted over the years to three one-bedroom apartments. The property is very valuable already, but lately there has been a tremendous demand for restored San Francisco–style homes, and the neighborhood has become very upscale. Single-family homes in the immediate area have been selling for $700,000 to $800,000. Jack and Barbara both like to keep busy and think restoring their property would be a great project and a way to spend extra time in San Francisco before moving to Palm Springs. This is a perfect situation for converting an investment property to a primary residence. Jack and Barbara will have to move tenants out to start the restoration project. But if they are willing to move in while working on the restoration, they can convert the property so that the entire triplex is restored to a residence and will qualify for the married couple’s $500,000 gain exclusion.  In California, that will save them approximately b$140,000 in a combined state and federal capital gains tax. In addition, the process of living in and restoring the property will probably enhance the property’s fair market value. All in all, it seems like a smart move on Jack and Barbara’s part.


The downside to converting or recharacterizing investment property to primary residence or partial primary residence is that the depreciation taken on the property, as discussed further in the next section, will have to be recaptured on the sale.