Couple wishes to convert second home into a primary residence. Can it be done?

Once the pandemic started and he could work from home, the second home became available. So, we started renting it. We would like to sell it and not have to pay capital gains taxes when we sell it, which may be soon.

My husband lived there part-time from the time we purchased it in October 2016 until around March 2020. So, under these circumstances, could the property be considered a “primary” residence before becoming a rental?

A: You’ve answered your own question. In your email, you say that the home your husband purchased was a second residence. He never made it his primary residence. You and your husband continued to use your current home as the primary residence and rented out the second home.

As much as you might like to rewrite the script, you can’t change a second or investment home into a primary residence simply through wishful thinking.

What does it take to make a second home into a primary residence? IRS Publication 523, Selling Your Home, explains: “An individual has only one main home at a time. If you own and live in just one home, then that property is your main home. If you own or live in more than one home, then you must apply a ‘facts and circumstances’ test to determine which property is your main home.”

What is the address on your mail? Have you changed your address to the second home with the U.S. Postal Service? What is the address listed on your voter registration card, federal and state tax returns, and driver’s license or car registration?

These are the primary tests for a principal residence. But the IRS also considers whether the home is near where you work, bank, the residence of one or more family members, and the recreational clubs or religious organization of which you are a member.

From your description of the way you and your husband used the home, we imagine that your husband used the property on a limited basis while he was working out of state. Had he changed his driver’s license or voter registration to that address, your husband might be able to make a claim that the home was his main home. But, it sounds as though he used it as an alternative to an extended stay hotel.

Given the facts you presented, we can’t see how that home could be considered your husband’s primary residence.

On the other hand, you’ve quite clearly converted that second home into a rental property. Now that the home is an investment, you may be able to deduct all of the expenses of running that investment. And, you may benefit financially from the depreciation you’re allowed to take on that property.

Remember, that when you sell a second home, you’d owe taxes on the profit. If you sell the second home at a loss, you can’t deduct that loss. Now that the home is an investment property, things change. When you sell it, you will also have to pay taxes on the profit on the sale of the home, but you have more options for deductions against that profit. If you sell the home at a loss, you may be able to take that loss on your income tax return.

We don’t have space to get into the details of what you would pay the Internal Revenue Service in taxes for the gain on the sale of the home or how you would take the loss on your taxes. You’ll have to discuss that with your income tax preparer or advisor. You may find IRS Publication 946, How to Depreciate Property, and this page of frequently asked questions on the Sale or Trade of Business, Depreciation and Rentals helpful.

Converting your second home into an investment property gives you another option when it comes to lowering today’s tax bill. From the description of your situation, if you sell and are willing to buy a replacement investment property, you can undertake a 1031 tax deferred exchange. This exchange mechanism under Section 1031 of the Internal Revenue Code allows you to sell the old investment property and buy a replacement investment property and defer the payment of taxes that may be owed on the sale.

The rules for 1031 exchanges are extensive, but in a nutshell: you must set up your 1031 exchange before you sell your investment property; use a company that specializes in 1031 to be the intermediary; designate a replacement property you intend to buy within 45 days of the sale of your existing property; and close on the new property no later than 180 days after the closing of the existing property. The purchase price of the new property must be at least equal or greater than the sales price of the property you sell. And, you can’t take on more debt than you had on the home you sold.

If you do it right, you defer the payment of taxes you otherwise would have paid on the sale of the property. This is a complicated move, and if you blow any piece of it, you could be liable for the entire tax bill immediately. You should consult with a tax deferred intermediary company for more information and to understand how completing a 1031 exchange will affect you today and in the future.

If you ultimately decide a 1031 isn’t the right move, for whatever reason, you’ll have to pay whatever taxes are due on the sale of the property. Your own tax preparer can help you further understand the future tax implications of this transaction.

(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through their website, bestmoneymoves.com.)