What specific IRS forms do I need to fill out to report the sale of a principal residence that was formerly a rental property?

Selling a principal residence that was formerly used as a rental property creates a "hybrid" tax event. You must separate the transaction into two distinct tax treatments: the exclusion of gain allowed for your home (Section 121) and the taxation of the "non-qualified" periods where the property was a rental (including depreciation recapture).

Because this property is your principal residence at the time of sale, the reporting primarily flows through Form 8949 and Schedule D, but you will likely need specific worksheets to calculate the taxable portion.

1. Introduction

When you sell a home that you have lived in for 2 of the last 5 years, you generally qualify for the Section 121 exclusion (250,000 for single filers; 500,000 for married filing jointly). However, because the property was formerly a rental, you cannot exclude all of the gain.

You are effectively reporting three "buckets" of money:

1. Depreciation Recapture: The depreciation you claimed (or could have claimed) while it was a rental. This is always taxable (max rate 25%).
2. Non-Qualified Use Gain: Gain allocated to periods the home was a rental (after 2008). This is taxable.
3. Qualified Principal Residence Gain: The remaining gain, which is eligible for the Section 121 exclusion.

2. Core Explanation: Specific Forms Required

The specific forms you need depend on when the rental use stopped. Assuming you converted the property to a full personal residence in a tax year prior to the sale (e.g., you moved back in 3 years ago and sold it today), you will use the following:

A. Form 8949 (Sales and Other Dispositions of Capital Assets)

This is the primary form where the sale is reported.

• Part II (Long-term): Since you likely held the home for more than one year.
• Column (f) (Code): Enter code "H" (for exclusion of gain on main home).
• Column (g) (Adjustment): Enter the amount of the gain you are excluding as a negative number.
  • Note: You generally cannot exclude the portion of the gain attributable to depreciation.

B. Schedule D (Capital Gains and Losses)

This summarizes the information from Form 8949.

• Unrecaptured Section 1250 Gain Worksheet: You must fill out this worksheet (found in the Schedule D instructions) to calculate the tax on the depreciation you took. This tax is capped at 25%. This is where the "recapture" is actually calculated and taxed.

C. Worksheet 3 from Publication 523

While not filed with the return, this worksheet is essential for calculating the exclusion amount to enter on Form 8949. It helps you allocate the gain between "qualified use" (time you lived there) and "non-qualified use" (rental periods after 2008).

D. Form 4797 (Sales of Business Property) - Conditional

You only need this form if:

• You used the property for business/rental purposes in the year of sale (e.g., you rented it out in January and sold it in July of the same year).
• If you converted the property to personal use in a previous year, you generally do not file Form 4797; instead, the depreciation recapture flows to the Schedule D worksheet mentioned above.

E. Form 8960 (Net Investment Income Tax) - Conditional

If your Adjusted Gross Income (AGI) exceeds the threshold (200k single / 250k married), the taxable portion of your gain (the depreciation recapture + non-qualified use gain) is subject to the additional 3.8% NIIT.

Audit and Practitioner Considerations

The IRS scrutinizes these "hybrid" property sales heavily because taxpayers often incorrectly exclude the depreciation recapture.

1. Common Challenges by the IRS

• "Allowed vs. Allowable" Depreciation: A common trap is assuming that if you didn't claim depreciation on your tax returns during the rental years, you don't have to recapture it. This is false. The law requires you to recapture depreciation that was "allowed or allowable." If you failed to claim it, you still owe the tax on it (and may need to file Form 3115 to catch up the missed deduction).
• Calculation of Non-Qualified Use: The IRS may challenge the ratio of "rental days" vs. "personal days," specifically looking at periods of vacancy. Vacancy between rental tenants generally counts as rental use, not personal use.

2. Disqualification Facts

• The 5-Year Lookback: If you have not owned and used the property as your main home for at least 24 months (730 days) out of the 5 years ending on the date of sale, the Section 121 exclusion is disallowed entirely (unless a partial exclusion exception applies, like a health-related move).
• Like-Kind Exchange (1031) History: If you originally acquired this property via a 1031 exchange, you must own the property for a full 5 years (not just 2) before you can use the Section 121 exclusion.

3. Documentation Expectations

• Schedule E History: You must have copies of Schedule E for every year the property was rented to prove the amount of depreciation claimed.
• Basis Records: Proof of the original purchase price plus all capital improvements (new roof, remodel) to accurately calculate the total gain.
• Proof of Occupancy: Utility bills, voting registration, or driver’s license updates proving exactly when you moved back into the property to establish the "qualified use" period.

3. Summary

4. Suggested Next Steps

1. Gather prior tax returns: Locate all Schedule E filings to sum up the total depreciation claimed.
2. Calculate Basis: Determine your adjusted basis (Purchase Price + Improvements - Depreciation).
3. Run the Test: Verify you meet the "2 out of 5 years" residency test.
4. Check 1031 History: Confirm you did not acquire the home via a 1031 exchange in the last 5 years.
5. Review Pub 523: Download IRS Publication 523 and use Worksheet 3 to estimate your taxable gain.