The Financial Samurai community rocks. There’s just so much collective knowledge from each of you that ensures the content published here (posts and comments) is as accurate and helpful as possible. As the conductor of the site, it’s my job to highlight as much good as possible.
In the post, Buy Real Estate For Capital Appreciation, Rental Income, or Lifestyle, I responded to one reader by mentioning potentially moving back into his rental for two years in order to take advantage of the $250,000 in tax free profits for a single person, or $500,000 in tax free profits for a married couple if he/they then sell within five years of moving back in.
Here’s a great response from reader, Yetisaurus,
Well, I hate to be the bearer of bad news, but the rule changed a bit starting January 1, 2009. It used to be that the $250,000/$500,000 exclusion applied so long as you lived in the home for any 24 months of the 5 years preceding sale. Now there’s an exception to the exception to the rule in section 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)
The IRS chomps away at the $250k/$500k exclusion amount based on a proration of the amount of time that you’ve held the property as a rental since January 1, 2009 (note that it goes back more than 5 years now to look at the use period). The one oddball exception to that (under (b)(4)(c)(ii)) is that if you lived in the home for 2 years during the past 5, and held it out as a rental AFTER you move out, that period is still counted as qualified use.
I mapped this out once about a year ago before selling my residence-turned-rental condo, and determined that it wasn’t worth moving back in to try to recapture a proration of the exclusion amount.
Example: Let’s assume you lived in the house for 2 years starting January 1, 2009, and then converted it to a rental for 2011, 2012, 2013, 2014, 2015, and then moved back in for 2016 and 2017 and then sold it January 1, 2018, you would have owned it for 9 years total and lived in it for 4. You would be able to exclude 4/9 of $250,000, and that’s it. Better than nothing, but if you’re reaching for the full amount of the capital gains exclusion, it’s not as generous an exclusion as it was before.
Bam! I dig the highlighting of section 121 (b)(4)(c)(ii). As you can tell from the example, as soon as you decide to rent your property out, your tax-free profit exclusion starts getting whittled away. One might suggest this person live in her place for longer to gain more tax-free benefits.
Let’s say the person moves back in for 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2027, 2028, 2029, 2030 and sells in 2031. They would have owned the property for 22 years, and lived in the property for 17 years. Instead of being able to exclude 4/9 of $250,000 ($111,111), they can now exclude 17/22 of $250,000 ($193,181) from the tax man.
The other solution is to never rent out your property, but sell once you want to move. The $250,000 / $500,000 in tax free profits is like making a $357,000 / $714,000 gross return on an investment for someone paying a 30% effective tax rate. That’s some big bucks! Take a look at the chart I put together for how much in gross profits you need to make with other investments at various effective tax rates.
Finally, instead of selling a property for a profit, one can simply conduct a 1031 Exchange by buying another property with the profits of the previous property sale so there is never a tax event. There is no tax shelter available for stock profits, but there is a powerful tax shelter for real estate owners, yet another reason why I prefer real estate to stocks.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org
As several commenters mentioned in my Passive Income Rankings post, tax considerations is a huge part of returns. Real estate might be second to the bottom of the list, but it’s at the top of the list of money-making assets thanks to depreciation, mortgage interest deduction, the 1031 Exchange, and the $250,000 / $500,000 in tax-free profits upon sale.
The higher your effective tax rate, the more you should love investing in real estate, maxing out your 401k, investing in municipal bond funds, and holding dividend stocks. You might even want to start a lifestyle business one day by launching your own blog.
Once you’ve got your platform online, you can find consulting gigs, new employment opportunities, sell other people’s products and earn a commission, sell your own products, and make advertising income. Not a day goes by where I’m not thankful I didn’t start Financial Samurai. If I didn’t, I wouldn’t be free today! Learn how to start your own blog today. It’s never been cheaper and easier thanks to technology.
Explore real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns.
Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Updated for 2019 and beyond.