To save on real estate capital gains tax, you may want to move back into you rental property. Capital gains tax can take a huge chunk of change away from your profits.
This article discusses how I’m having a difficult time being a landlord for one of my long-time rental properties. But given I bought it in 2003, if I sell, I’ll have a massive capital gains tax to pay.
Save On Capital Gains Tax By Moving Back Into A Rental
So far, I’ve eliminated most stressors due to financial independence:
- Commuting to work
- Working with people I don’t respect
- Sitting in mindless meetings
- Working in an occupation that started getting boring after 13 years
- Dealing with unreasonable clients
- Worrying about how to afford raising a family in an expensive city
- Having to respond to endless e-mails
- A rental house with maintenance issues that consistently attracted rowdy tenants
My last stressor I can eliminate is getting rid of my SF rental condo I bought in 2003 for $580,000. I dislike working with the HOA board, who is made up of grumpy old retirees who seem to have nothing else better to do than to grandstand. They hate landlords. They also hired an incompetent property manager who only responds to the board, instead of all homeowners they work for.
In 2017, a similar unit across the hall sold for a surprising $1,360,000. The unit had about ~$40,000 more in upgrades than mine due to a remodeled kitchen, but everything else is the same. The buyer was a 26 year old associate in banking and his girlfriend.
The problem with selling my property is that I would pay a 27% marginal tax rate on the gains. We’re talking a potential ~$200,000 tax bill. Further, I’d lose out on $4,200+ a month in rental income and a place for family to stay close by if ever needed.
One solution to minimizing the tax bill would be to move back in tomorrow, live in the condo for the next two years in order to get the $500,000 tax-free profit exclusion, and then sell. Some of you real estate investors are likely facing the same dilemma. Let’s talk it out.
Related: How To Pay No Capital Gains Tax For A Home You Sell
Saving On Capital Gains Tax: Be Aware Of Depreciation Recapture Tax
Depreciation is a non-cash expense you get to deduct from your rental income to minimize your taxable rental income. For example, you might have $10,000 a year in rental income after all expenses, but pay zero income taxes because you have $12,000 in depreciation. You don’t need to worry about paying it back until you sell the property.
Because depreciation is an accounting tool that lets you “use up” the value of your asset, the IRS expects that you will sell it for less than the depreciated value. If you sell your asset for more than its depreciated value, which is almost always the case, the IRS requires you to pay tax on that gain. This tax is called “Depreciation Recapture Tax” and is also referred to as Section 1250 recapture.
The tax rate on recaptured deprecation is 25 percent. Consider a rental property that you bought 15 years ago for $580,000 and plan to sell for $1,300,000. Your analysis shows that $400,000 of the value was in the depreciable building and $180,000 was in non-depreciable land.
You would have a $720,000 capital gain on the difference between the original purchase price and the selling price, taxable at 20 percent in the 2018 tax year ($144,400 in taxes). In addition, the $14,545 per year depreciation that you claimed based on the asset’s 27.5 year life, which adds up to $218,181, is taxable at 25 percent as recapture ($54,545).
This leads to a total federal tax bill on the sale of $198,945 before taking into account the cost of selling the place and all the renovation expenses.
I don’t know about you, but paying almost $200,000 in capital gains tax just to get rid of tenant, maintenance and HOA stress seems like a hefty price to pay.
Yes, you would walk away with around $1,100,000 in the bank if you sold the property. The money could be invested conservatively at 3% – 4% to generate $33,000 – $44,000 a year in passive income compared to the current $36,000 a year net rental income you gain.
But still, is it worth it?
The Math And Sacrifice To Move Back In
If my family moves back into our 1,000 sqft, 2 bedroom, 2 bathroom condo we will be losing 920 sqft of indoor space, 220 sqft of deck space, a bedroom, an office, a yard, and a hot tub.
What we gain will be a lovely park view with a maintenance-free massive yard right across the street. The park has two renovated tennis courts and a great playground for our boy. The condo is in a central location making going downtown and coaching high school tennis easier as well.
Given the condo capital gain is more than $500,000, we could save around $91,000 in taxes if we moved back in for two years and then sold. Further, the condo has no mortgage, only ongoing HOA, utilities, maintenance, and property taxes to pay.
Meanwhile, we could either leave our current primary residence empty for that two year period, foregoing ~$6,000 a month in rental income, or $144,000 for two years. Or, we could hopefully find a nice family to rent it out partially furnished. But then there’s the stress of dealing with tenants again.
The other thing we could do is sell our beloved primary residence today for what we believe to be over a $500,000 tax-free gain, reinvest the proceeds, move back into our condo rental, sell it in two years to take advantage of another $500,000 tax free gain, sever all roots in San Francisco, and buy a sweet blogging pad in Hawaii before our son goes to kindergarten in 2022.
The final option would be to sell both SF properties tax-efficiently, reinvest all proceeds passively into real estate crowdfunding, bonds, and dividend stocks, and move back in with our parents in Honolulu rent free. Of course we’d pay for all maintenance, utility bills, and property taxes if we move in. The investments could potentially earn $15,000 – $20,000 a month passively and we’d save almost $6,000 a month in homeownership costs.
Update: Unfortunately, based on the Housing Act change in January 1, 2009, I’ve got to prorate the exclusion based on the “qualified use” divided by the number of years of ownership. My qualified years is therefore, 2003, 2004, 2005, 2006, 2007, 2008, 2018, 2019 (if I move back in for two years) = 8. The total years of ownership if I move back in for two years = 17. Prorated exclusion = 8 / 17 = 47%. 47% X potential gain of $720,000 = $338,823. Not bad, but not $500,000 as I was hoping. Here is a post with five examples detailing the proration rule for tax free profit exclusion.
Every Two Years Is A Blessing
I knew there would be a lightbulb moment when I wrote, How To Pay No Capital Gains Tax After Selling A Property For A Huge Gain. This decision we face is very real as we’re trying to optimize our lifestyles today by minimizing stress.
We think raising our son in family-friendly Honolulu while caring for my parents now that they are in their 70s is an ideal set up. Our boy won’t go to pre-school for another 1.5-2.5 years, so the time is now. Yet, we’re hesitant to move given we’ve been in San Francisco since 2001. Life is comfortable with our network of friends.
Not having a single property in San Francisco seems foolish 20 years from now. I’m certain San Francisco will become a mainstay international city where people from all over the world decide to come. It’s already happened in places like Sydney, Vancouver, New York, Singapore, and London. But it’s most important to live in the present.
Honolulu property should do OK over the long-run as well. But it won’t perform nearly as well as San Francisco property because the local economy isn’t nearly as strong as the Bay Area’s economy. Honolulu property prices are dependent on tourism and investors who’ve already made their money elsewhere.
Moving Back Into A Rental Review:
* Calculate your actual tax savings to know what you’re playing for. There is a prorated amount you need to calculate after you have more than three years of non-qualified use (rental, home office, etc).
* Find the difference in rental income you could potentially earn renting out your primary residence and subtract the rental income lost from moving back into your rental.
* Write down a list of all the non-monetary pros and cons of making the move.
* Consider whether a 1031 Exchange is a better option.
* Ask yourself whether you want to live in the now or in the future.
Note: Always check with a qualified accountant when it comes to making tax moves. As a practical matter, in order to qualify for the full homesale exclusion under the Code Sec. 121(a) two-out-of-five year ownership and Use Rule, the nonqualifying use after the owner leaves his principal residence can’t exceed three years. After three years, the tax free exclusion gets prorated by the total amount of qualified years divided by the total number of years you’ve owned the property if you’ve lived in it for two out of the past five years.
Explore real estate crowdfunding: If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. They allow everyone to invest in mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals. They are the pioneers of eREIT funds and they are creating an Opportunity Fund to take advantage of tax-efficient Opportunity Zones. Thanks to technology, it’s now much easier to take advantage of lower valuation, higher net rental yield properties across America.
Related: A Potential Capital Gains Tax Hike Should Change The Way You Work, Invest, And Live
hi, i purchased a two family house in Queens in 1987, i lived there until 1994, it has been rented ever since. i am planning to move to the house and live there for two years. i Paid $260,000 for the house, now it is worth 950,000.
Do you think it is worthy to move back?
or can you give me an idea how much i would have to pay either way
i will really appreciate your help.
Olga
Hi, if I’m still renting at age 41 (albeit a low $700/mo rent, sharing a 4-bd 2.5ba house w/ garage and huge yard with 2 housemates), does it make sense to do the geographic arbitrage approach and invest w/ RealtyShares or similar crowdfund? Note I’m not an accredited investor so will need to find an alternative to RealtyShares. Since starting my new job last year April 2017, my savings-investing rate is $40K/yr. THus far, maxed out 401K and put about half of the remaining ~$20K into index funds, so have about $42K in cash. Wondering if I use that for 25% downpaymt for a rental property somewhere low-cost (eg house <$150K) or find a RE crowdfund to invest in?
My favorite alternative to RealtyShares is Fundrise for non-accredited investors. They have some very interesting eREITs to look at.
Sorry if this is a remedial question but you, and a couple other commenters mentioned, “sell both SF properties tax-efficiently”. I’m looking for help on what that means. Is it just 1031x being referred to here? The sec 120 cap gains exclusions? Or are there other tax-efficient strategies around selling?
I ask because I’m trying to figure out how to handle my primary residence situation. I bought it in Sep 2001, then moved out in Feb 2010 to go overseas for my employer. The first rental started in Apr 2010 and the last ended in Oct 2017 when I moved back in. I was originally moving back in thinking to stay for the 2 year period to exclude cap gains. But as I read up on the way that works, it is sounding like it might not be worth it to me to finish those 2 years. Assuming I sell in late 2019 and understand the time accounting correctly, I’ll have 8/19 = ~42% non-qualified, or approx ~58% qualified, right?
My gain won’t be anywhere near as much as the sweet SF appreciation you’re talking about, let’s assume $400k max, so I can exclude ~$240k from cap gains. So I’m basically saving myself ~$48k in cap gains taxes if I live in the property for 2 years. And I’d have to pay cap gains on the non-qualified amount of ~$160k, plus the depreciation recapture.
So I’m curious what other strategies for selling tax-efficiently without waiting the 2 yrs might be. 1031x would allow deferral of all cap gain and depreciation recapture, right? And maybe can I exchange into crowdsourcing if I didn’t want to purchase directly? Is there anything else to consider?
Sell your primary residence. Hand your condo off to a management company and let them deal with the hassel of the HOA.
Move back to Hawaii so your son can get to know his grandparents. Surf, enjoy life and think about your next move. Living in a small condo for two years to save money that you do not really need is detrimental to your family relationship and your mental health. Aloa!
First world problems!
Two options I looked at when selling my long term rental. The wife did not want to move back into it, period.foot.down.
Some of the real estate crowd funding sites are offering 1031s now. Help you avoid the tax. The ROis were unimpressive, however at 6 to 7%.
There are charities that will take the property in a charitable remainder trust. You can get tax deductions and possibly some income. These deals can take time to setup, but with your financial acumen, could be an option.
I recently read every RE article you have published on your blog. You make some great points in this, more recent article but your previous pro property arguments are still very very valid.
You divested a rental last year (or was it this?) but did that de stress your life. Most of the proceeds from that sale were not reinvested into real assets – how would this affect you in a downturn?
I would take more time to weigh up the options.
I think the 1031 option is the simplest especially with the newer options to 1031 into crowdfunded deals. Also, living. With parents sound great in theory, in practice it has been quite stressful on my marriage.
How long did you live with your parents? And what were the stresses it put on your marriage? Free baby sitting! :)
Nothing is free :p it’s the same situation with some of my other friends utilizing parents. Most of the conflict is usually with the in law side. Also, my wife has a lot of disagreements over how to parent etc. anyways for us it boiled over to the point where mother in law is moving to an apartment near by, so best of both worlds. Honestly, it’s similiar to any roommate situation just extra stressful because kids and parents are involved. If you and your spouse have zero issues with parent personalities small chance it may work.
I had a boss who owned five rentals. And house hopped for two years in each after retiring to avoid all the capital gain.
I’d say move back to the rental; rent the other place out and find great tenants and hire a management company to deal with landlord issues. Life is all about quality and reduction of stress/maintenance of health the older we get.
Sam,
Have you ever considered a deferred sales trust? It may be something to consider if you want to sell but are looking for a tax efficient way to do it. There would be fees of course in setting it up, but it would allow you to defer the taxes and pay them only as you receive distributions from the trust. It can also be useful as an estate planning strategy for your son.
You could also look into doing a section 1031 exchange into an upREIT. In that case you sell your property but instead of looking for replacement property to roll the proceeds into, you invest in the upREIT and receive an security interest in the REIT. Capital gains are deferred until you sell off your interests in your REIT.
Never heard of an upREIT. Will look into it. I did speak to a revocable living trust lawyer for two hours the other week and I’ll mention this as well. Thanks
This is a really tough one, Sam.
I’d consider moving back in based on my current personal situation (currently living in a 2/2 rental in Chicago with just my wife and our small dog, Stella).
Overall, I had to vote NO…the hot tub got me.
For your respective situation, as you noted in some of the comments above, I’d keep the rental and stay in your current primary residence. If and when you do decide to make the move to Hawaii, you might want/need a place to say if you want to visit SF. You might have the option to sell your current primary residence if you’re interested in a smaller home away from home (in your current remaining SF rental). – Mike
Heh, the hot tub really has been a fantastic investment. It is amazing.
I agree that it’s wise to always have at least one property in SF for a pied de terre or a place for family to stay. SF is my favorite city in America, followed by NYC. I blew my chance of not buying in Manhattan in 2001.
I would sell it and smile at the already good gains. Your dream is to go to Hawaii so do it. It is a very consentrated investment and there is far better ways to get real estate exposure which is also broader. With technology you can visit any time, airbnb etc. if you want to. Good luck with the choice!
Imo reduce the stress, investment concentration and seek a more passive means.
Have you considered what would happen if the magnitude 8.3 earthquake of 1908 hit San Francisco in the next few years?
What would happen to housing prices?
How many businesses and companies would be able to withstand the hit of closing down for a few months?
Would the economy recover ? Or would other ascending areas find an opening, get momentum and move ahead?
What is the likelihood of such scenario?
I think you should multiply the probability of this black swan scenario times the monetary impact and incorporate the resulting expected value into your calculations and decisions.
I think there will be a 20% – 30% drop in home prices for the first 12-24 months, and depending on the severity of reduction in supply, prices will rebound over the next 36 months, provided there isn’t another huge earthquake. What do you think?
Im not that optimistic and have assigned a higher expected value discount for that geological risk when it comes to my Bay Area real estate.
I don’t mean a “big” Earthquake like the ’89 Loma Prieta where businesses reopened in a week. I mean the more or less scheduled repeat of the 1908 8.3 magnitude quake where most major water lines get severed and a significant percentage of businesses have to close for months due to buildings deemed too risky to be reinhabited without major repairs and retrofits.
I consider this a modest but not insignificant factor in my Bay Area real estate valuations. Especially if Bay Area real estate is in bubble territory this sudden event will push it over the edge.
My general valuation philosophy when looking at Bay Area real estate is that the area has some technological momentum, but that can be replicated. So can the enviro-nimby supermajority coalition that keeps supply choked and price inflation rampant (it is actually a joy to see the children of environmentalists becoming my renters because they cannot afford anything else, or getting priced out of the area altogether, but that’s another story..).
What cannot be replicated is California’s geographical endowment of good weather. But that endowment is finite — and is already supporting a 10x housing price multiple over the rest of the country. Can this finite geographical endowment support infinitely rising price multiples; to 15x, 20x? Remember the advantage depends on geographical factors, and whatever those are they are nonetheless finite. The risk of bubble is I think higher than most people think. Capitalization ratios in Bay Area rentals imply that people expect roughly seven percent housing price appreciation … in perpetuity. I’d say this enters irrational exuberance territory.
Hence: Buy Utility, Rent Luxury (BURL)
Could not agree more… and I assume we must do the utility vs luxury distinction based on price points. Based on that the Bay Area has no more utility left. It’s all luxury. The question is whether it’s bubble luxury or not…
Go for Hawaii Sam!
My uncle is on Kauai. When I saw him last time I was thinking how great a place it would be to grow up as a kid (I can’t complain with Colorado).
You have made a great life in SF but with your family the next chapter might be better served in Hawaii. It will also help you get out of the buzz of SF and into the soul of the islands.
Life is short…make your dream happen.
Oh yes, going to Hawaii is almost a certainty, but the question is whether to move back into the rental to save on taxes and then sell in two years. I’m leaning towards no, and will have a new post to explain why. Much different from why I sold my other rental last year.
Living on Kauai would be quite different than living in Oahu, where Sam wants to go I believe. Kauai is straight out of a dream of heaven. I would pick Hanalei Bay. I can’t imagine a better place for a kid to grow up in the USA.
The best decision is what is right for you.
Right now you’re an RE owner/operator and successful blogger, but you’ve got some top priority additions in your life – the demands of fatherhood and eventually caring for your parents. Your SF-concentrated RE has paid off handsomely, but just as importantly, your transition into truly passive RE syndication sets the path to focus on what matters most as you focus on family and figure out your legacy.
This is why I voted to sell both tax-efficiently and move to Hawaii and fulfill your dream.
I’ve followed a similar path, as I sold my Inner Sunset duplex this Jan for 2.5m and have repositioned a lot of my capital during this late cycle M2 explosion. I love Realtyshares and Crowdstreet for the ability to invest with professional operators that have developed systems for scale and are able to handle tax reform nuances like cost segregation. Some even have great banking relationships that allow quick refinances that speed up the velocity of your money. Talk about kicking back and watching the mailbox money come in. The main difference of our path is that I lost my parents at a young age, so I can truly attest that being there for your parents is key. But for your sanity, maybe not living in the same house :)
As always, keep up the great content. You’ve easily helped me add over 1m to my net worth.
Congrats on the $2.5M sale! Can you share how much you bought it for and when? Things definitely feel late cycle, but I doubt we’ll correct by more than 15% here in SF. Uber and Airbnb have yet to go public.
Do you plan to move out of SF?
So awesome to hear I’ve helped you with your financial journey!
Paid 2.05 in 2015. It was by no means a homerun deal – our agent did well by getting us in and out. However, what it taught me was that I should re-allocate more RE exposure to the pro operators until I get more comfortable with direct ownership.
We paid 925k for our lowernob condo Jan 14 and the same floorplan two floors down just sold 1.34m. Not massive appreciation, but something to try to maximize if we decide to leave SF. We have a 20mo and another one coming in July, so I’m trying to map out our plan. We’re 2 years into our 7yr 2.5% i/o arm and I think we’ll live here for 2 more years, then rent out for 2 years, and sell at ideally 1.53m or more so that we maximize the 500k tax-free gain. It always feels great to maximize on tax breaks!
Over the years we’ve talked about living in Burlingame, San Mateo, Pleasanton, etc. Now we’re open to the idea of living in Japan, Singapore, Scandinavia, etc. *shrug* Suffice it to say that we don’t want to live the conventional SF-grinder lifestyle, but we want to enjoy our beautiful city while we’re here.
Ah, cool. A win is a win. I think you’ll like an upcoming post on family travel I have in store. Congrats on #2!
K.I.S.S. Keep it simple stupid. Minimize all stressors in your life and enjoy your life. Get rid of the expensive overpriced coastal real estate while you are still ahead, delever, remove headaches and move to paradise/Hawaii. Either live with parents there or buy a confortable place for you and your family. No point buying a ‘sweet pad’. That’s another headache. Try to be satisfied with consuming less material things, and yes that includes real estate. I know you have brainwashed yourself into the whole buy buy buy real estate until yours and the banks last leveraged dollar runs out, go ‘neutral’ inflation, but trust me, there are other assets out there, and they all have to owned, sold and rebalanced periodically and measured against each other in terms of leverage, risk, performance, liquidity, correlation, volatility, carry. I do this for a living, and have been successful at it for decades. I’ve never owned real estate and have instead leveraged my investments in liquid asset classes, balanced dynamically and have far outperformed my local coastal (other coast) real estate over the long term, in terms of net return on cash, as well as adjusted for volatility, taxes and liquidity. Meanwhile, I’ve also enjoy my rental homes, just as much if not more than others’ ‘owned’ real estate, along with the liquidity and freedom that comes with it. I cringe when I hear the term ‘throwing money away on rent’ or ‘the return on rent is always -100%’. It’s such an incomplete and illusionary analysis. I know you will find that hard to believe, but please do try. You seem to be a sophisticated investor and financially literate, and so do your readers, so I find it very naive to push only one asset class, borrow all the money you can and put all your eggs in one basket. Of course you can be right/lucky, but its not good asset allocation/diversification. You’ve won the dangerous, concentrated, leveraged game you played with SF real estate, now simplify, diversify, build some passive income and protect your assets while trying to grow them modestly, coast, blog if you like (another headache it seems), enjoy your time and your family and quit losing sleep over material aspects of life including that perfect real estate/pad.
You’re right in that most of my gains are based on luck.
But I’m not sure if you’re right about me being brainwashed to buy, Buy, Buy. If I was, why would I write this post talking about selling?
And if I was brainwashed, why would I have sold one of my rental properties last year? See: https://www.financialsamurai.com/why-i-sold-my-rental-home/
I’d love to know more about yourself to understand where you are getting your views and where you’re coming from.
I will correct myself. Previous to selling your property last year and your current consideration to sell your rental condo and maybe even your primary home (and perhaps your Lake Tahoe condo?), you seem to have been extremely partial toward real estate to build wealth (any enjoying it while you live in it), specifically coast real estate, even more specifically SF real estate, and to drill down further – Golden Gates Heights and a couple of other small neighborhoods in SF. I fundamentally disagree with being partial to only to small subsets of one asset class, and concentrating all leverage, net worth and liquidity there. As an investor who has the ability to allocate to real estate, equities, fixed income, credit, foreign exchange commodities, other alternatives in multiple geographies I prefer to run a diversified portfolio and rebalance. I use leverage, and go long short. I’m not saying real estate can’t be a good investment. I’m also saying that you can build a net worth just as easily without owning real estate and paying rent for your primary residence. I have personally and professionally done exactly that over a long period. I love reading your blog, have followed it for a very long time, and it’s no secret you love(d) real estate. You have written countless posts on real estate as the best asset class or alluded to it in many other posts, you have kept buying real estate with the notional value far exceeding your net worth, you have said the return on rent is -100%, etc. Come on, if you are to calculate the return on renting, you have to include the return on the alternative investment you are going to pursue with the cash you won’t be tying up to buy a house! It’s a simple calculation, but most people don’t bother. They are happy to follow the well known mantra to buy your home or you will be poor forever and get eaten up by inflation. I know many many rich people who have done the same as I, i.e. rented as it was cheaper, invested their cash in hedge funds, private equity, equities, fixed income with leverage and better liquidity and done better. Meanwhile no ownership headaches, no surprise repairs, increase in monthly costs and real estate taxes, and now no more SALT and real estate tax deduction limitations! Not to mention the constant renovations, remodeling, that makes my head spin even watching it from a distance. I have seen healthy loving couples almost strangle each other and divorce over a stress gut reno! At some point, you have to ask yourself how much materialism is enough? Does it really matter what your faucets, sink, toilet, tiles are? I’m getting a migraine just thinking about it. I don’t mean to start an argument with you. I love reading your unique perspective. Other personal finance blogs are utter crap. You have written great posts and you are a great communicator, and you have an open mind. I have even enjoyed reading your real estate posts! Getting back to your question in this post – I am glad that you see things differently now as a family man, your priorities have changed and I believe you are now truly trying to diversify your assets and lower your leverage. You are also trying to simplify your life, and reduce headaches so that you can do what’s truly important – enjoy your health and your beautiful healthy family in Hawaii, although CA is beautiful too.
Ah, big paragraphs.. hard to read. But I got through it!
Perhaps I write with too much passion and intensity on most subjects that it makes it seem like everything I write about is something I’ve invested the vast majority of my wealth in? Maybe I need to be a disclosure statement at the end to remind new and old readers where I’m coming from. What do you think?
I love real estate for the most part, better than stocks. But real estate hasn’t been more than 40% of my net worth in over a decade. In fact, my exposure to real estate is now quite similar to my exposure in stocks.
Related: Recommended Net Worth Allocation By Age Or Work Experience
Sorry yes too long! I apologize. I write with passion too on occasion, but obviously not as well as you do. You are the writer, not me.
Don’t worry about adding a disclosure I think, although it may not do much harm either. You don’t have to answer to anyone, it’s your blog and you got FU money!
40% of net worth is not so bad, and I’m glad its lower now. When you say 40% of net worth, do you mean your entire real estate exposure is 40% of your net worth or the equity in your real estate is 40% of net worth? In the first case your home is worth 400k for example and your net worth is 1M. So exposure to real estate = 40%. In the second case, your home is worth say 1.5M, your home equity is 400k, your net worth is 1M. Exposure to real estate = 150%.
Cool. Tell me about yourself. Are you retired from Corporate America as well? If not, what’s stopping you?
What do you consider Corporate America? I have never worked for a large firm with layers of management and bureaucracy. I work in managing investments, but I enjoy my work, find it stimulating, more of a ‘vacation job’ you described in your earlier post. Whats stopping me is trying to figure out if I have enough to FIRE, and the fact that I actually enjoy my work, I’m *only* 40, I don’t work long hours, no commute, spend plenty of quality time with my young kids, and I get paid 500k-1M at the minimum.
My primary reason for wanting to retire would be to escape the constant grinder feeling you get in HCOL living cities like NYC and SF. SF and surrounding areas are beautiful, but living there feels like a grind. NYC has so much to do, eat, culture, etc. but a true grinder.
Sounds like a great vacation job to me! I would keep doing it if Enjoy your work for sure.
Sam,
Why not do a 1031 exchange for a property in Hawaii. Rent that for two years, and then move into it?
-D
It is a good plan. The only problem is that the Honolulu rental market is very soft. Rents are down about 20% from its high, and the house that I want to buy to live in is definitely not going to run to Well because it is at a higher price point. Which also begs the argument that it is probably best to rent such a house then to buy. But I’m going in with the attitude that I want to lowball all these houses that of been sitting for a couple years And try to get a great deal and then just on the house forever. We shall see.
You have the potential to live anywhere, think about that for a bit…if moving to a “paradise” state where you have family already isn’t the plan A, I believe you are not maxing your full potential of FS. You can make new friends- you could create new parts to FS – it can be hard to know when you have won the game with investing -But FS can grow well beyond a great blog with loyal readers.
Agree 100%. I felt the best when we were traveling around the world or living in Tahoe for 1 month, Hawaii for 3 months, SF for 7 months, and around the world for 1 months b/c we could continue to run our business, have fun, and write about new cool things.
But we’re locked down for the first 2 years with our boy, so that’s quite a change from so much freedom… MAX freedom actually… for the 2 years prior after my wife left work. It’s fine… but we know by this time next year we’ll want to make a change.
Ahh, glad to hear you made the most of your cool situation!
The other thing we could do is sell our beloved primary residence today for what we believe to be over a $500,000 tax-free gain, reinvest the proceeds, move back into our condo rental, sell it in two years to take advantage of another $500,000 tax free gain, sever all roots in San Francisco, and buy a sweet blogging pad in Hawaii before our son goes to kindergarten in 2022.
That would be my choice. And all that time you could use to scope out the sweet blogging pad before you choose it. Sounds perfect
That’s a lot of “Yes” options but only one “No” option. There were a couple of No options I personally would want to consider:
No, I would sell the condo and pay the $200k capital gains tax bill ($135k more than if I moved).
No, I would hire a property manager to deal with tenants.
No, I would keep the Condo empty and would wait until I found the Honolulu property of my dreams then sell the condo to take advantage of a 1031 exchange.
Here’s another way I thought about it: if I lived in a 1000 sqft 2BR/2BA condo with my wife and son and you told me I could move into a house that was almost twice as big, with an ocean view, and dedicated space to use to earn more passive income (i.e. your home office) for only $135k I would do it in a heartbeat.
You’re right, I’m totally biased and wanting to sell (and get rid of stress). But I can just add up the total Yes’s and compare that percentage to the percentage voting NO.
I enjoyed how you mentioned both quantitative factors (e.g., future returns) as well as qualitative factors (e.g., raising your son and caring for your parents).
However, as a California CPA, I would have to agree with another commenter above that you will likely not qualify for the full home sale gain exclusion under Section 121.
I actually wrote a blog post recently about the home sale gain exclusion, and in light of your article, I added a new section called “What If I Rent Out the House and then Live In It and then Rent It Out and then Live In It Again”?
In my article, I actually mentioned your post and linked back to it!
I also used your numbers (rounded) and rough timeline (with some assumptions) for my example in the article.
Long story short, it appears to me that you will likely have a 6-figure federal tax bill on the sale even if you move back in for 2 years. Including California taxes (depending on your tax bracket of course), you could be looking at a nearly $200,000 combined federal and state tax bill.
Obviously it’s even worse if you don’t move back in with a potentially $300,000 + combined federal/state tax bill.
1031 probably makes more sense in this case if you do end up selling the condo.
Click on my name above, and you will taken to the article!
Oh and being a fellow blogger, I would of course appreciate a follow backlink if you have any to spare.
Thanks and take care!
(This comment and any information on my site are merely informational and are not intended to be taken as tax advice.)
Good stuff. Haven’t read the article yet, but have my own article I worked on last night to clarify the proration.
I think about this a lot, as I have a condo but know I would like to purchase a house in the near future.
At the risk of sounding … shady … since there is no mortgage, can’t you use the condo as your “primary” residence (stop renting), but simply continue to spend a lot of your time in your main home? And then sell in two years, with no capital gains. You would lose the condo rental money, but this is small potatoes without a mortgage.
I’m assuming in your scenario you don’t have a mortgage on your primary residence? And you’re not claiming property tax deduction on it?
Sure, you can do that or anything you want. But there are consequences if you get audited.
The cost of not renting is not just your carrying cost. It’s the cost of forgoing the monthly rent, which in my case, would be $4,200/month.
Hi, Sam: I thought you mentioned real-estates in mid-west republican states has higher cap rate? Why not simply do a 1031 and buy some multi-family unit there and hire some manager to collect rent? We currently own a few condos in bay area that pay meager 3% cap rate, and would love to consolidate them into a commercial building or multi-family unit somewhere in those republican states that can pay 8-10% cap rate.
Another option is since you have plan to eventually move back to Hawaii, maybe selling your current condo, do a 1031 into a Honolulu property, rent it out for now, until you’re ready to move back to Hawaii?
I’m waiting for real estate crowdfunding to have more 1031 Exchange options to make it easier.
1031 exchange to Honolulu is a great plan.
Hi Sam – have you considered doing a 1031 exchange? Delayed exchanges are the most common, but a reverse exchange can be more optimal if you have the capital.
Definitely. It’s in the post.
Hmmmm…tough call I suppose. I voted that you should sell both and move to Hawaii just based on keeping it simple but it doesn’t seem like there is a bad option on your list. I think whatever is best for your family is the right choice…although based on the information that you provided I think we all know what you want to do:)
YEah…. I went back and forth for a long time regarding selling my SF rental house in 2017 thanks to the community’s input. Now I’m thinking about doing the same with the SF rental condo. Man… there are some sick homes one can buy on or near the beach in Hawaii if I sold.
Temptation. I fear change, so I’m trying to work my way through it.
You’ve written at length about how much you like real estate as an investment vehicle. Do you think indirect investment in real estate through crowdfunding platforms is equivalent to property ownership for investment quality and asset allocation?
I think in your position I’d choose life and my happiness over the cash if I thought the cash was still sufficient to maintain a happy lifestyle. Time is the expiring asset that you can’t get back or reallocate.
It’s not equivalent from a feel good pride of ownership POV. But so far, it’s been good from a returns point of view with no maintenance.
Sam,
I have been reading your site for quite a while now. I have been in the workforce in the Silicon Valley meat grinder for about 10 years and already I am getting tired of managing rentals on the side and hustling etc etc. I can only imagine how you feel after doing it for so much longer than me. Honestly, it sounds like you will be fine no matter what route you choose, so for once in your life feel free to take the easy way out, whatever that means for you personally. You’ve earned it!
-DDave
Make that money DDave and get out as soon as you can! I’m trying. Just need to properly plan to minimize disruption. I think when my boy is 2-3 in 1-2 years, we’ll be good to go.
Considering commuting to a city job is not on the table, I’d much rather live in Hawaii. If you can get paid (through tax savings) to live in San Fran for two years, it seems like an easy call to do so.
Obviously, your day to day life matters more than anything at this point though. Financially, locking in tax savings is great. But where do YOU want to live?
Out of curiosity, when you had potential tenants looking at your rentals, did you have a system to screen them to determine if they might be “rowdy” ones down the road?
I’ve thought about someday purchasing a rental property, but that is my greatest fear for owning one.
Thanks so much!
Sure. Check these two out
https://www.financialsamurai.com/how-to-select-the-best-tenants-for-maximum-peace-of-mind/
https://www.financialsamurai.com/example-of-a-good-residential-rental-lease-agreement/
Those are great! Thank you!
Reinvest the gains in an opportunity zone to avoid the capital gains tax. You’re prob still on the hook for the hook for the depreciation recapture.
I voted for keeping the SF house and condo, only because keeping the house and selling the condo was not an option. I would sell the condo and invest the proceeds in the stock market. In fact, I did this herein Vancouver 6 years. I had a house and a condo, found the condo too much hassle, but a house in Vancouver is like winning the lottery that keeps on giving. I would never sell the house in Vancouver. The condo was just stressful for reasons you site, and I had plenty of exposure to real estate. I invested the proceeds of the condo sale in the stock market with return of about 20% pa easily. With your proceeds in one year you would easily make back the taxes you would pay. My proceeds account is funding my travel these days. Meanwhile the MV of the house continues to rise. I have two small rental units in the house (the main house is 2700 sf, plus 1000 sf unit plus 500 sf unit, which offsets costs.
From your posts, you are already under extreme stress, so you should not make any moves now that will add to stress. Make some simple moves to relieve stress, like hiring nanny, cleaners, gardeners. Make more time to socialize as that is your relaxer.
I would spend part of the year in Hawaii near family, e.g.rent a house nearby parents twice a year for a month. For myself, would not buy real estate in Hawaii due to long term danger of global warming and rising seas. Also, too far from everything and you never go back to an expensive city. If I did move to Hawaii full-time, I would rent a place there, and rent the SF house — easy to find great tenants — for a 2-year trial.
Another thing, when I go through all these torturous what if’s, I usually conclude that I should stick to my plan. I don’t worry about money excessively because my plan shows that my NW will keep increasing and my income will keep increasing to provide plenty of travel. My plan estimates taxes until 2035, so I can minimize those. My plan takes into account the stock market going down 30% and then recovering over 2.5 years without me reducing income. I can survive that and much worse set backs. My investments are straight forward and do not take much time to monitor. Capital gains taxes paid when I sell stocks only.
Ah, how nice it would be to continue making 20% pa in the stock market from here. I’ll take the under on that assumption and hope for just +5% this year.
I’ve been mesmerized by beach front property in Hawaii. But yeah, everybody talks to me about global warming. The funny thing is, all our properties are on a hill with a view now. Maybe that trend should continue.
My stress is elevated due to the dual responsibility of this site and childraising and HS coaching, but it’s not at extreme levels yet. Coaching finishes this Saturday (We’re in the finals whoo hoo), and my little one is slowly sleeping better through the night. Just planning ahead.
The 20% returns are bonuses, I was very lucky. I make my projections based on reasonable return 0-5%, and then on 10-15-20 % returns and different burn rates. Then I can see the range of possibilites, which is a huge incentive to do better. I don’t make 20% every year for sure.
My dream is property with a spectacular view, does not have to be oceanfront, but walkeable to the beach, because I enjoy the walk to the beach, and climbing the hill every day is so good for health. But spectacular views do not come cheap in the city. I may eventually go to a penthouse as much as I hate the condo hassles.
I think you do amazing with all you and your wife take on, and you keep everything going, so you don’t get behind. Testing your limits and resolve is good to build confidence that you can get through anything with a smile and style. Your life is stressful (normal not extreme), and looking back you will realize that you didn’t have to worry so much. I am a worrier too, and can’t/don’t want to change that, just keep it reasonable. I have learned not to make drastic U-turns just because of one bad patch, to relieve stress in small ways, keep with the plan. But I usually don’t launch into unrealistic dreams or other people’s dreams any more. But I still reevaluate to optimize happiness and confirm I am good. I achieved my 3 big life goals years ago (publish a book, own a house, become a professional), which means my goals were too conservative. So I keep the spectacular view house on my agressive goals list. About 8 years ago, I decided to quit all commitments (volunteer work, contract jobs) and empty my life as much as possible to see what would come in to fill the gaps. The idea was that what I really really wanted would be clearer. I was so worried that my life would not be as stimulating. Wrong, better than ever, meet tons of great people travelling, etc. Anyway, I do get the beach front property in Hawaii goal and you will know when to make the move.
I just love your recent posts, on life and money. To put things in perspective, I ask myself (and friends), would you give up good food for $65 million. You would have to eat strictly from standard low-mid-market level chain grocery stores and chain restaurants. No cheating with gourmet chains. No to fresh produce from the farm market, no visits to the butcher or cheese shop or really good bakery no great coffee beans. When travelling, same, tourist restaurants and chains. Only 1 in ten would take the money (those that live on pizza and fast food), but we all realize that we are already living like billionaires.
How did your last property sale work out now that the tax numbers are all finalized? You can use experience from that last sale to make your decision.
I’m sitting on fat property gains also and likely won’t sell. I’m just going to leave them as is, once I’m gone my heirs get it tax free, maybe.
Pretty good. Not as bad as I thought.
We have four rental condos in great areas in Chicago. I have this fantasy of selling our primary residence and taking turns at each condo before we sell. It would be a lot of fun to live in those areas (Gold Coast, Lincoln Park) but we would have to downgrade living space to a third of our current.
I’d question your assumption about SF Real Estate in 20 years and wouldn’t bat an eyelash.
As your son gets older, you will appreciate SF less and less as the ‘fabulous’ place to raise him.
(I’m in the second decade of my son’s life in SF)
Move to Hawaii. Travel to SF whenever you desire
Given your experience, can you elaborate why San Francisco my not be a great place to work or live or raise a family 20 years in the future or now?
I would sell both properties efficiently and move to Hawaii in a few years. That’s your dream so make it happen. The gains are awesome.
We’re planning to move into our rental duplex as soon as our tenants leave. Unfortunately, they’re not planning to move anytime soon. That’s okay for now, but I’d like to move before our kid goes to middle school. So I’ll have to give them notices in about 4 years. Who knows.. I’m pretty sure they’ll be ready to move by then.
You could raise their rent in the meantime, and give them a little more incentive to move earlier. Unless you’d rather wait the four years. Sometimes rent increases can be good motivators.
I’ve been increasing rent for the last few years. There is a 10% rent increase cap now so that’s how much rent is going up every year…
Oh, gotcha. 10% is pretty hefty. Nice work!
Depreciation recapture can be a huge wake up call if you decide to sell your primary residence and have been depreciating a home office as part of a business too. Just something to think about because there are many more entrepreneurs/side hustlers using their home for a business and taking the deductions. It’s a risk you take up front in case you need to sell your home and move.
I would recommend you talk to a CPA who can advise on this. I’ve read up fairly well on Section 121 (I’m not a CPA), and the situation you are describing would not allow you to exclude 500k gain, even if you move back in. Since this was a rental first, then primary residence, you could only exclude the gain on the residence that occurred while you lived there during those 24 months. Basically the IRS already anticipated a bunch of landlords pulling off what you just described.
It was actually a primary residence first for two years back in 2005 and 2006.
I’m happy to hear clarification from CPAs. There is a prorated amount for the two years you have to live there as your primary residence for the use test. So for example, if you needed to sell the home for whatever reason after just one year of living there, you can get half the benefits.
The depreciation recapture tax is what is necessary during your rental years.
I don’t think the fact that it was owner-occupied first saves you. If I’m reading it correctly, you take the period from 1/1/09 to date. You allocate gain between nonqualified use and qualified use. Nonqualified use = years from 2009 to date that it was used as a rental property. Qualified use = years from 2009 to date that it was used as your primary residence, and also years after you moved out of the property BUT ONLY in the last 5 years before you sell it (i.e., 3 years max of freebie credit there). See section 121(b)(5)(C).
So for 2009-2017, let’s say, it would be unqualified use, and for 2018-2019 it would be qualified use (assuming whole years). If you sold on 1/1/20, I think you can exclude 2/10ths of the gain on the property, up to a max of 500k.
Depreciation recapture would apply as well. If your total gain was going to be around $2.5 million, I think you’d get the benefit of the full 500k exclusion if you moved back in for two years.
Uh oh, you are right! And we’ve discussed this before when the topic last came up. Amazing how easily I’ve forgotten.
This seems to be the bottom line: As a practical matter, in order to qualify for the full homesale exclusion under the Code Sec. 121(a) two-out-of-five year ownership and use rule, the nonqualifying use after the owner leaves his principal residence can’t exceed three years. After three years, it looks like the tax free exclusion gets prorated.
http://www.floresattorneys.com/popup-newsletter.php?PageID=294798
Let’s say you’ve owned the property for 10 years and move back in for two of the last 5 years. What is the prorated math for exclusion?
Sorry to deliver the bad news. I know we talked about this ages ago, but it’s hard to remember. I had to re-examine 121 to be sure before I responded to your first comment.
Yes, I think it would be prorated even if it was bought after ’09 and lived in for 2 of the last 5. If you bought and moved in right away, and then moved out and then sold it within 3 years of moving out, then no proration. But if you moved out for more than 3 years, that effectively re-sets the 2-out-of-the-last-5-year primary residence clock, so it would require proration. :(
I found the post where we talked about it and where we clarified it a couple years ago. Amazing how time flies.
Clarifying The $250,000 / $500,000 Tax Free Profit Rule
Guess I need to publish a refresher after this!
The answer to my question in the comment is: 2/10th X $250,000 / $500,000 if one lived in the rental for 2 years of the last 5 years and owned the house for 10 years. So $50,000 and $100,000 is tax free.
Haha! Great find! Just one point of refinement: you can still use the full 250/500k exclusion, it’s just that you can only apply that exclusion to the portion of gain eligible for it (the qualified use portion).
So let’s say your qualified use is 20% of the time you owned the property. You take your total gain (say $1 million) and multiply by 20% = $200k. You can take that whole 200k exclusion.
If your total gain were $2.5 million, your qualified portion (20% of it) would be $500k, and you could use the whole $500k exclusion.
So it’s the percentage of gain that gets chopped down by the proration, not the $250k/$500k cap.
Yep indeed. Final point to clarify. You can get the full exclusion if you buy the home today, live in it for 2 years, rent it out for 3 years, then sell. But what if you buy the home today, live in it for 4 years, rent it out for 2 years, and then sell for a total of 6 years. What is the percentage exclusion? Does it suddenly drop from 100% eligibility to only 4 / 6 (67%) eligibility?
So long as you buy it, move in right away, and then sell within 3 years after moving out, you get the full exclusion.
Years before 2009 still count toward the denominator in the nonqualified use fraction. It’s just that all years before 2009 are considered qualified.
Good catch! You’re right.
It’s for this reason that I NEVER make a property “rental first”. I always live in them first. What seems to be not yet determined by tax case law though (at least that I’ve been able to find) is how long that “I lived in it first” period needs to be and/or what proof I need to show (a single utility bill? a dated picture of my bed?). Is a month good enough? Why or why not?
Clearly the asset over the past 15 years has been good for you. Sell it and be done with the stress.
If it was me, I would do a 1031x and a refinance to pull out the equity out of the home at the same time. You could easily pull out a decent chunk of cash to be used else where without incurring a tax liability.
The refi happens on the new property you purchase*
You’re going to want to look further into this. I believe the capital gains tax exclusion is prorated to the time used as personal residence vs the time used as a rental.
I think ParatrooperJJ is correct. Take a look at Internal Revenue Code Section 121(b)(4) that breaks out qualifying use vs. non-qualifying use. There is a calculation where only a prorated amount of the gain can be excluded depending on how many of the years you used it as a Primary Residence vs. a Rental.
You guys are correct. Post updated and a new post with prorated examples coming up!
I’m in a similar situation, but was told by a broker than the 2 years out of the last 5 don’t have to be contiguous. Bought my condo in L.A. as a principal residence in July 2003, rented it out for the first time in December 2015. Current lease is up by end of April 2019. So could I move back into it for at least 5 months (May-October) to recapture the 2/5 rule and then sell to maximize the exclusion? My understanding is that because I first used it as a principal residence, the qualifying use rules are different. I also had a home office for a few years, but the depreciation was fairly limited and I know I’ll be paying recapture tax on that as well as the 3 years when it was used a rental.
Thumbs up for you not having to work with people you don’t respect! In my head, I was like, wow, that must be REALLY nice lol
Also, I’m all for keep the property, but then again, I don’t believe in selling, only buying.
It’s a dream come true to avoid folks you don’t like. You don’t realize how long you put up with other people’s crap until you finally get to stop.