Save On Capital Gains Tax By Moving Back Into A Rental

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.