To avoid capital gains taxes on the sold property, could I use the profit and invest in the other house, or am I required to use it on a whole new property to avoid the tax? Also, if so, how long am I required to rent the house before I can move into it again without a penalty?
Before we inquire about capital gains… do you have a long-term gain, short-term gain, and how large is it? When did you buy the rental property and what is your cost basis. There has not been much noise recently about 1031 exchanges given that real estate values have tanked about 20% nationwide.
If your gain will indeed be large then you may want to consider a 1031 exchange or a structured sale. However, be aware that all you are doing with either is delaying the tax. Consider your long-term goals… if it is your intention to convert to cash or some other type of investment at some future date then consider timing on when to pay the tax. Frankly, I would rather pay a tax today rather than in the future as I know what my exposure is currently. Although we do not know what taxes will look like in the future, does anyone believe that they will be less than today? A structured sale will allow you to pay the capital gains over a period of time.
If it is your intention to pass your assets to the next generation, then tax deferral to the very end makes sense as your heirs will inherit you rental property at a stepped-up costs basis.
We personally own a fair amount of rental real estate as do many of our clients. We like the use of peer-to-peer lending and lease/purchase as an alternative to renting or selling. So, rather than selling your rental property outright, sell it as an owner-financed property. You get a nice down payment, monthly lease payments, while property taxes, insurance, and maintenance responsibilities belong to the leasee.
I am not clear what you mean about moving back into it again. If you are living in a house that is your primary home then the first $250k (husband/wife $500k) in gains per person is not taxable if you have lived in it for 2 of the last 5 years. But be very careful as the rules are highly complex regarding primary homes, vacation homes converted from one to the other, and rental property. Finally, beyond taxable gains, be aware of depreciation recapture, where the depreciation offset to current rental income comes back to bite you.
There are a lot of complex moving parts to rental properties and way too many variations to try and discuss here… consult with a fee-only advisor who has experience with real estate and consult with a CPA.
Your first question: 1) Can I use the proceed from the sale to invest in the other property. I recommend confirming it with your tax preparer but my understanding of 1031 exchanges is that it cannot be used to improve an existing property and needs to be used to purchase a like kind property. 2) Here is the link for the IRS's explanations of Like Kind 1031 exchanges http://www.irs.gov/uac/Like-Kind-Exchanges-Under-IRC-Code-Section-1031
The second question, again I would encourage you to discuss with your tax preparer but my understanding is that if you have owned a rental property for a long period of time and convert it to personal use, there is no tax because there has not been a sale. My understanding is that it is allowed by the IRS. Similar to being able to convert personal property to rental property you do not need to recognize a gain in that scenario either (again because there is no sale).
Now if you question is can I 1031 exchange a property into a house I intend to use for personal purposes, how long until I can use it personally? I would advise extreme caution as the IRS could view the transaction as a means to avoid tax and that your never intended the new property to be used for business purposes.
I would classify that attempt as very aggressive (from a tax perspective) and would fear the IRS look at the transaction as merely trying to avoid capital gains tax. Again, I would highly encourage you to have a frank discussion with your tax preparer. These are not tax issues I would expect a do-it-yourself person to be able to answer and with the amount of tax you could be talking about, I think it would be worth it to consult with a tax expert.
To sum it up: 1) If you sell to buy another business/rental property, you can defer tax 2) If you convert a long held rental property to personal use, you can defer tax 3) If you sell a rental and buy a house you intend to use for personal use, you will likely owe capital gains tax. 4) Review with your Tax preparer BEFORE you act.
Best of luck,
Rental property can be somewhat tricky. For starters, have you checked comps for similar properties in the area? You may find that this site can provide you with more insight into homes in the neighborhood where your rental property is located: www.realtytrac.com.