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