The $250,000 / $500,000 tax-free home sale profit rule is a fantastic benefit for homeowners who have lived in their homes for two out of the past five years before selling. The rule is also called the tax-free exclusion rule for real estate.
The tax-free profit exclusion rule essentially says if you are single, you can earn up to $250,000 in tax-free profits. If you are a married couple, you can earn up to $500,000 as a married couple. This tax-free exclusion rule is one of the reasons why real estate is my favorite asset class to build wealth for regular folks.
If you are in a top marginal income tax bracket, then the tax-free home sale profit rule becomes even more valuable. For example, imagine if President Biden raises the highest marginal tax rate to 39.6%. To earn $500,000 in profits after tax, you would need to have a gross profit of roughly $833,000!
The tax-free profit rule seems straight forward. However, there may be some confusion. So let's clarify using an example!
Clarifying The $250,000 / $500,000 Tax-Free Home Sale Profit Rule
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 tax-free profit exclusion. I said they would have to then sell within five years after moving back to get the benefit..
Here's a great response from reader who is a tax lawyer about earning tax-free capital gains after selling a home. The tax-free exclusion rule has some nuances you should be aware of before moving back into your rental to save on taxes.
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. I 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. You then converted it to a rental for 2011, 2012, 2013, 2014, 2015. Then you 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.
Renting Out Your Property Hurts The Tax-Free Home Sale Profit Rule
Bam! I dig the highlighting of section 121 (b)(4)(c)(ii). As you can tell from the above 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. Here's another example.
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.
A 1031 Exchange To Defer Capital Gains Tax
Finally, instead of selling a property for a profit, one can simply conduct a 1031 Exchange. A 1031 exchange is where you buy 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, except if you reinvest in an Opportunity Zone fund or investment. But there is a powerful tax shelter for real estate owners. A 1031 Exchange is 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
Always Calculate The After-Tax Return On Your Investment
As several commenters mentioned in my Passive Income Rankings post, tax considerations is a huge part of returns.
Real estate isn't at the top of the list due to the work required. However, 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. You should also be maxing out your 401k as well. If tax hikes happen, investing in municipal bonds will also be more attractive.. You might even want to start a lifestyle business one day by launching your own blog.
When it comes to achieving financial freedom, it's all about generating as much passive income as possible. Take a look at the short-term and long-term capital gains tax rates yourself. It's obvious that it's more tax-efficient to earn more passive investment income for a better life.
Explore real estate crowdsourcing opportunities.
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Real estate is a key component of a diversified portfolio. By investing in a diversified eREIT with Fundrise, you can easily gain high-quality commercial real estate exposure across the heartland.
Another fantastic real estate platform is CrowdStreet. If you are an accredited investor, CrowdStreet focuses on individual real estate opportunities in 18-hour cities. 18-hour cities have lower valuations, higher cap rates, and higher growth rates. The spreading out of America is real. Take advantage.
I personally have $810,000 invested in real estate crowdfunding across the heartland. So far, I've received over $624,000 in distributions and passive income.
Post-pandemic, I think the housing market will perform well for years due to the structural undersupply of housing. However, with mortgage rates rising rapidly due to inflation and the Fed's rate-hike cycle, demand for real estate should wane. This is your opportunity to look for deals and invest.
The Tax-Free Profit Exclusion Rule is a Financial Samurai original post. I've been writing about personal finance since 2009. Financial Samurai is one of the largest independently-personal finance sites with over 1 million organic visitors a month. Subscribe to my free newsletter below.
62 thoughts on “Clarifying The $250,000 / $500,000 Tax-Free Home Sale Profit Rule”
I bought my house four family in 1978 I have lived here ever since I want to sell it now does my husband and I get the $500,000 nontaxable when we sell
You should. But double check with your agent and accountant.
I’ve owned a rental for 16 years that I lived in for 2 years before buying another primary home 2 years ago. I also own a primary home in AZ and live in each 6 months. I’ve depreciated the rental except for the 2 years I lived there. Do I get the $250K exemption or do I get 1/8 of the exemption (2 out of 16 years), or do I get a big fat nothin? Thank you!
Spoke to my accountant about this recently. It would be 1/8 of the exemption
Helllo, I am selling my studio in a coop building in New York City. I have some questions around IRS 121 exclusion, Capital Gains Tax. I purchased a studio for $ USD 180,000 in June 2001. I resided in studio for 13 years from June 2001 to Sept. 2013.
On Sept 2013 I moved to the Philippines due to a job offer. My nephew occupied the unit from 2013 to 2017 and paid no rental. My tax filling did not reflect rental income nor any depreciation for the unit during this period. The unit was rented from July 2017 to July 2020 (3 years) and I have claimed depreciation as part of my tax filling for these years. I am now selling the unit at USD 400,000. After selling the unit, I have no plans of using the gains to purchase another property or re investing in real estate. Based on my limited experience, I believe can deduct 6% broker fee, 3% Coop Flip Tax, approximately 2% NY and State tax from the Selling Price. Is my understanding correct?
I believe that although I am a USA citizen, I am considered as a non-resident due to the length of time that I have been away and might not be eligible to use the one time tax free profit exception of USD 250,000 as a single person based on the IRS 121 exclusion clause. Is my understanding correct? I would like to know how much CAPITAL GAINS TAX that I need to pay from selling my unit.
I purchased a home in foreclosure for 155,000 I used it as a vacation home for 5 years and now have used it as a vacation rental for a year and a half. I want to do a 1031 exchange for a property equal in value of what I can sell this property for. It will probably sell for about 375,000-400,000. Can I put the house on the market now instead of waiting the extra 6 months ?
It is not my primary residence and never has been.
I bought a property in 2012 and lived there until middle of 2018. I have been renting it out for one year. If I sell the property within 3 years after moving/renting it out, am I still eligible for the whole $250,000 (single)/$500,000 (married) capital gain exemption? Or it needs to be prorated?
You should be able to take the whole $250/500k exemption. Consult your favorite tax pro to be sure, but if you bought in 2012 and moved in right away, and you lived there for more than two years and then converted to a rental and sold within 3 years of moving out, you should be able to take the whole thing. There may be some depreciation recapture if you depreciated part of the property after turning it into a rental. But consult your tax person to be 100% sure. Or if you normally prepare and file your own returns using TurboTax or some other program, open your last year’s tax file, save as a new file, and pretend you sold your house. See what it does to your tax situation.
Here is our situation. Purchased a duplex in 1995, we resided in the back and rented the front for 24 years (claimed the income of the rental). Since then the renters moved out November 2018. and is now vacant as we fix it up. We are still living in the back. Daughter will be moving into the front unit. So I would call it our home (compound) vs an investment rental. We purchased the duplex for 300K now worth 2M. We owe a little shy of 400K. So, my question is:
If daughter plans on living there (or we keep it vacant for two years). Do we qualify for the 500K deduction. If we sell we would buy a single family home (and the 1031 does not apply). Wondering how much if any of the 1M equity we would need to pay the tax man.
I am married and planning to purchase my Personal Residence in California under single member LLC. What about the 121 exemption if I purchase it under single member LLC?
I have the same question.
Hello. After a long drawn out process trying to sell my house I finally have a buyer. It has been just over three years since I moved out of the house and into my new one. I never rented the old house, had a couple different sales fall through over the years. Am I now out of luck completely for the capital gains exclusion as I have only lived in the house 20 months of the past 60 despite having no renters?
Look up the rules on prorated exclusions. See if one of the allowable reasons such as health or job move apply to you.
Thanks for the feedback Dave, I did review those and unfortunately would not qualify for any of them.
Hi. With both tax plans it looks like real estate capital gains exclusion will go from 2of 5 years to 5 of 8 years. My question is will this be retro active or implemented for properties purchased starting in 2018? I’m contemplating selling in 2018 but have lived in the house 3 years. If the plan is retroactive to propterires purchased prior to 2018 then it may keep me in my current house for 2 more years, which I hope is not the case. Thanks for your help.
Yetisaurus, or anybody subscribed to this thread. Quick question:
Do you have to live in the property for 2 of the last 5 years to get any benefits? What if you live in your house for 1 out of the last 5 years? How does the math work?
What about if you live in the house for 1.5 of the last 5 years before selling. Does the IRS include the half a year as a full year in the 2 out of last 5 year calculation?
Let’s use an example:
Purchase year: 2005
Years lived in it: 7 years
Rented it out for: 3.5 years
Total years ownership: 11.5 years
Is the math 7 / 11.5 = 60.8% X $500,000 = $304,347 in tax free profits for married couple?
or is the math
7 / 12 (b/c the IRS allows you to round up your half year of living as one full year) = 58.33% X $500,000 = $291,666?
Or, is it possible that because the person hasn’t lived in the place for a full two years, there’s an even greater reduction in the benefit, or no benefit at all?
If you don’t meet the 2 out of 5 rule, you don’t get any cap gains exclusion at all. Sorry, man. I had the same problem with my rental condo. :-/
But what about if you lived in it for one year and 10 months. Does the IRS allow you to round up? How will the IRS know you didn’t live in the place for exactly 24 months out of the past five years?
On the tax return I think they make you report the move in and move out date. You could write whatever you want, but I think it’s under penalty of perjury and if they audit you they might require bank statements or utility bills or some other proof that you lived there for that time. Or if you had tenants in the property at any time near then, they might require documentation to show the tenants moved in after the date that you reported moving out.
Short answer: you could always lie, but it might come back to bite you.
Hi Sir, I have a question:
I brought a land in 1980($32,000) and sold the land in 2004(#300,000), use 1031 exchange to purchase a single family house for renting. Now I am thinking to sell the rental. Can I move to the house as the primary resident for two years and take the $ 500,000 couple exemption?
I have lived in my condo for 2.5 years and I have lived in it as my primary residence the entire time. I rented out my guest room to a friend for 0.5 years. I claimed this as rental income on my 2014 taxes, and deducted some expenses. I am now selling. I am single/unmarried and making less than $250,000 profit. Will capital gains and/or recapture taxes apply? There are similar questions on the internet, but mine is different because it is not a rental property, I just rented out a room within my primary residence/single family dwelling for a short period of time. I am in CA if that matters. Please help.
Clarification. I deducted expenses, but not depreciation.
First, a little bit of bad news. I think you should have taken depreciation for that portion of your house for 2014. The good news is that it’s not too late to amend your 2014 return to take that depreciation. If you don’t take the depreciation, you will still be deemed to have taken it and it will reduce your basis in the property on sale.
From the IRS:
Claiming the correct amount of depreciation. You should claim the correct amount of depreciation each tax year. If you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted.
If you deducted an incorrect amount of depreciation for property in any year, you may be able to make a correction by filing Form 1040X, Amended U.S Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in chapter 2 of Pub. 527 for more information.
Next issue: the capital gains. Read IRS publication 523. https://www.irs.gov/pub/irs-pdf/p523.pdf I pulled it up and read it for the last 25 minutes. It seems to me (in my fast reading) that you are required to figure your basis as if you took depreciation, whether or not you actually took it. (This is why you want to go back and amend 2014.) You take the sales price, minus expenses of sale, minus that depreciation. That’s your gain.
Then, on p 14 of the publication, you calculate how much of the gain is excludable. If you don’t meet both tests listed (and it seems that you don’t), you have to recapture that gain that you just had to amend your return to deduct. That recaptured gain is taxable at the recapture rate (25%) and the rest is excluded if below $250,000.
Read it for yourself and make your own determination. I gotta get to work so I can’t dig into it any deeper. Good luck!
Explain to me WHY a married couple gets twice as much deductible as a single person, (me) when I paid full price for my
home, did it alone, paid the property taxes, alone…
I think, I SHOULD get the same amount… or more.
I feel discriminated. It’s hard enough being single. Why shouldn’t I get the same benefits?
Because before people are married, they are single, and single people also pay “full price” for their homes and all the taxes along with it.
Given this string of posts has enduring value, it would be worth updating the introductory material under the caption “Here’s a great response from reader, Yetisaurus: … on 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)”
Per the notes at the bottom of https://www.law.cornell.edu/uscode/text/26/121, P.L. 113-295 fixed the duplicate (b)(4) error. The second subparagraph (4) is now subpargraph (5).
Please scroll up to see another response from me. There is a formula documented. And how years are treated changed along the way….
Please help! We sold a rental house and the profit we 1031 exchanged it to another rental house. We rented the new rental house for 8 years since 2006 up till 2014. Now we moved into the rental house as our primary house since last year of 2014 and by Sept. 2016 we will be living in this house for 2 years. are we qualify to get the 250k/500K if we sold this house since this house is a 1031 rental ? Is 2 years all we need to live there as our primary residence to qualify for the tax exemption ? Another question is .. is there a chance that we can sell it sooner maybe 18months to live there only and sell and still qualify for the capital gain tax free ?
Rules have changed. I think you used to be able to get away with something like this, but not anymore. You’ll have to do a bit of research to clarify the details, but I think you can only qualify for a small share of the 250/500, like 2/(years since purchase of first rental), and I think you’ll also have to pay taxes on depreciation.
Highly insightful info.
I need to understand one technicality:
Currently, spouse and I own/live in a Single-Family house.
In about 2.5 to 3 months we move to our new bigger house (we are in contract, but only get possession in June). How do I ‘formalize’ my move-date for Tax purposes? – This would be the date my current residence ceases to be my primary residence.
Once I have that date – my deadline would be 3-years from that date, as discussed above – to reap the full $500k exclusion. Crossing the 3-year mark unintentionally could be an expensive mistake…
Owning rentals through a trust is particularly safe. Naming yourself the current beneficiary and remainder beneficiary, but hiring a fiduciary to act as a trustee whom will manage all rentals, is perhaps the safest method of real estate rental investments.
Because all profits are funneled through the trust and taxed at an individual level ..instructed in the trust document… (the beneficiary) cannot ever be liable for any mishaps or lawsuits arising from the rental properties. Only the trustee can be liable as well as the trust can be at risk, but a trust per property protects other properties.
Just found your website and really excited to learn valuable investment advices from you. Im in process of buying a house(townhouse). SHould I go with 7/1 ARM (saves me about $150/month) or 30 year loan? I think at some point I will want to upgrade to regular house in the future and was thinking about selling it. But reading your post of keeping property as long as possible for appreciation, make me think maybe i should go with 30 year fixed. any suggestion?
Question: If you live in a house for a number of years, then move out and rent it for a little over 3 years, is any exclusion available to you at all? For example, suppose you sell after 4 years. Do you still get half of the 250 / 500 K exemption, since you lived in the house for 1 of the past five years?
If the answer is yes, a followup question. Suppose the capital gain were only 50K, and you lived in the place 1 of the previous 5 years (the above scenario). Since this gain is less than half of 250K would you get the entire gain tax free? Or would you only get half the gain (25K) tax free?
Unfortunately, no. You have to own and live in the house for at least 2 years of the 5 years prior to sale in order to get any portion of the exclusion. Take a look at Internal Revenue Code section 121 if you want to see the details.
Yeah this is really good information, we actually had a talk about this in the past couple months of moving and then making a decision within those 5 years to decide if a long distance rental was working well for us or we should sell within the first 2 or 3 years at most.
So using estimated numbers if we live in the house for 5 years to rent it out entirely, and then decide in year 8 to sell. Is it my understanding as a Married Couple we would get 5/8 of 500K tax free or around 312K of the profit?
If you bought the house and immediately moved in, and lived there for 5 years, you could then rent it out for up to 3 years (so long as it’s sold before the expiration of the three years) and exclude the entire gain up to $500k. It’s only if you rent it out for longer than 3 years and try to move back in to recapture some of the gain exclusion that the proration comes into effect.
Bingo. In other words, there’s a 3 year “grace period” everyone gets for the tax-free profit exclusion.
Thanks for the great info everybody! Here is a quick question I had. Say you bought a property and instantly started renting it out for some number of years. Then at some point in time you go and live in the property yourself for 2 continuous years as your primary residence at which point you decide to sell. In the eyes of the IRS would you be able to exclude the $250K/$500K in capital gains the residence has gained through appreciation over the years?
If I misunderstood your hypothetical, though, I apologize. I wasn’t clear on whether you already owned the property and have been living there for 5 years, or whether you were planning to purchase a new property.
Timely article. Was just discussing selling our primary residence with Mrs. E and was going to look into the capital gains situation.
Great to hear of the exclusion! It’s useful articles like this that keep me coming back for more.
Great post and interesting topic. I didn’t realize the rules had changed (real estate is lower on my list of investments), and it certainly does influence one’s strategy.
One question / brainstorm – if you currently qualify for a fully excluded gain and are thinking of converting to a rental, could you consider selling your property to a corporate entity under your control, take the full gain (at a price you’d need to support with market comps, given the related-party angle), and then start your rental adventure with the higher basis? It seems owning a rental within a corporate / limited liability entity is a good idea anyway, so I wonder if anyone’d thought through this as a strategy.
I’m hoping someone answers your question, because I’m interested in the answer, too.
I think b/c your name would be the owner of the corporation getting the step up, it isn’t going to fly. Not sure though.
Owning rental properties through an LLC does seem like a good idea for liability protection. That said, you can just got a large umbrella policy instead.
My gut feeling about that was similar to yours. I don’t think you’d want to own it in a corporation anyway, because real property ownership in a corp presents some negative tax consequences. If you later want to dissolve the corp and distribute the property to yourself, you have to recognize it as a sale (even if you’re the sole shareholder) and pay cap gains tax on it then. With an LLC or partnership you could dissolve the entity and distribute it out to yourself without recognizing the gain.
I was thinking about a sale to a related LLC, though. I think it doesn’t work if you have one-member LLC, because that’s disregarded as a separate entity for federal tax purposes. In fact, owning it through a single-member LLC counts as “ownership” for the purposes of meeting the 2-year requirement in IRC section 121 (the $250k/$500k exclusion section). (See https://www.law.cornell.edu/cfr/text/26/1.121-1 at section (c)(3)(ii).) I can’t imagine the IRS would look through the entity for the purpose of establishing ownership, but then treat it as a separate entity if you “sold” the property to that LLC to use up the gain exclusion amount.
But a two member LLC could work. What if you form a 2-member LLC where you give or sell a friend a 1% interest in the LLC? You probably have to do it in the right order. I don’t think you could form the LLC, contribute the property, and then sell the 1% membership interest to your friend, because that’s not a sale of the property, it’s just a sale of a membership interest. But if you formed the LLC with your friend as a 1% member, and then sold your property to the LLC, maybe it would work. You’d get reassessed for property taxes, though, so you have to consider that. And you’d have to pay the $800 annual LLC fee and maybe an LLC tax, too depending on the gross amount of rental income. There are lots of moving pieces.
Create a trust. Have the LLC owned by the trust.
But it would have to be an irrevocable trust with its own FEIN to be treated as separate from the homeowner. Revocable trusts are disregarded for tax purposes. And if it’s an irrevocable trust, that has other ramifications. Who’s the trustee? What are the distribution limitations? What if you want to sell or gift the real estate property, or leave it to someone or charity instead of whoever is named as the successor beneficiary in your irrevocable trust? Plus there may be big gift tax consequences at the time you form the irrevocable trust. You’re making a future gift to the next line of beneficiaries who will inherit after you die.
This is excellent information to know. I also had no idea that the rules had changed. My plan wasn’t to buy/sell house for a profit, it was to reinvest it in another property, but it is still great information because that was my plan B.
Stupid question, but how would the government ever know that your property was ever rented? And/or what type of auditing would be done if any?
The government would know the property was rented if you reported the rental income on your tax return and depreciated all or a portion of the property and deducted other expenses (HOA, maintenance) in connection with the rental. You could just not report the rental income and not take any of the deductions (i.e., commit tax fraud), but that seems like a very, very bad idea.
Oh. One other thing. If you have owned rental property for a long time and move back in. The rules state that the time before 2009 or so counts as owner occupancy even if you rented it. So if you bought a property say in the 1990s and move back in now for two years you can get a significant percentage of the 250 or 500 exclusion. And keep in mind the percentage is based on the percentage of GAIN not the percentage of 250 or 500. So if you are fortunate enough to have a million dollar gain you might get the full 500 exclusion by moving back in. WOW.
Hi Dave – Thank you for the clarification. I’m a bit confused and, if you’ve got a sec, maybe you can help me out?
I bought a condo in 2000 as a primary residence and lived there until end of 2008. The place has been renting out since October 2008. First of all, am I still required to move back in for two years to get any kind of exclusion? What if I just sold it in 2016 without moving back in?
And say I did moved back in in 2016 and sold it two years later in 2018, am I correct that I could exclude 10/18 of the capital gains?
Thanks for the help!
You have to meet the the 2 of 5 rule. So yes have to move in for two years. Then it will be 10 /18 as you said.
DANG! Didn’t think about that either. HI FIVE DAVE!
I bought my rental back in 2003, and began renting it out in 2005. So essentially, 2005, 2006, 2007, 2008 count as not being a rental then for my tax free benefit if I move back for two years and sell within five years.
Thank you government!
I’m moving back into my condo that’s been rented out for quite a few years exactly because I thought I could do the $250K tax free sale.
Then I discovered the section 121 (b)(4)(c)(ii) “gotcha” but also saw the 2009 start date (I’ve had the condo rented out since 1999 so I will still get a good fractional rating from the sale). But then I also found out about the “depreciation recapture” which whittled my “tax free” sale bit down even further! And the document I read it in said the depreciation amount was taxed at 25% (not even what you’re prevailing tax bracket rate was but a flat 25% – need to look into that further to see it that’s really accurate).
But all-in-all I still think I can save a chunk of tax money by doing this so I will be moving back into the condo soon!
Thanks for your great site and the great information you post here!
That’s great that you can do that, Rick. Sounds like it will save you quite a bit of money!
You’re right about the depreciation recapture, unfortunately. It’s a flat 25% rate for federal tax, regardless of your tax bracket. You can calculate the amount of your depreciation recapture and see if a portion of it might be excluded due to some unusual circumstance by reading the instructions for Form 1040 schedule D and filling out the “Unrecaptured Section 1250 Gain Worksheet.” Or to make matters simpler, here’s a calculator I found online: https://www.orexco1031.com/Calculators/CapitalGains.aspx.
Thanks Yetisaurus! I’ll check out the 1250 Gain Worksheet and see if I can come up with an estimate, but to be honest when the time comes to consummate the sale I’ll actually hire a tax person to do my taxes that year (I normally always do my own taxes myself because I like to know the details myself)!
Wow that is one sweet and insightful comment! Sure highlights the complexity of the IRS tax code, which is probably much thicker than a dictionary. Really helpful food for thought as a property owner. Thanks!
Oh, wow. I didn’t expect my wee little comment to turn into a post. I’m flattered!
Another thing that you probably already know but didn’t specifically mention is that the IRS allows for the combination of the 1031 exchange and the $250k/$500k cap gains exclusion. That makes your scenario even better, because you can step up the basis in the new property by the amount of the section 121 excluded capital gain. That basis can then be depreciated in the new property, and/or will reduce the amount of cap gains you pay if you sell the new property.
Rental real estate rocks. The only real downside to it that I can see is that if you HAVE to sell for some reason (like I had to sell my rental condo), you typically get whacked with a huge cap gains tax (plus net investment income tax plus AMT in my situation) all in the year of sale, rather than easily being able to spread it out like you might be able to with the sale of stock. It’s easier to sell chunks of stock or other investments over several years, but with real estate you don’t really have that option. You could try selling real estate via the installment sale method, but that’s hard to do unless you’re willing to carry back a note from the buyer–no thanks! But in general, I totally agree that real estate is a fantastic long-term investment.
By the way, I’ve been lurking in the shadows reading your posts and the comments for months now, and have learned a lot of new things. I’m just now dipping my toes into Prosper, which is exciting. Thank you for the info you provide for all of us!
Such an informative post and comments. Thanks to you both.
Do either of you happen to know how this would apply when we’re renting a room in our primary residence? It’s simultaneously a rental and our primary…
If you are doing it by the book you will be taking a fraction of depreciation of the whole house which represents the portin rented. That fractional depreciation is still subject to recapture when you sell. But you still get the FULL 250 or 500 exemption by the same rules as a regular owner. If you happen to move out and rent the whole place before selling. The proportional rules outlined above kick.
You bet! Thanks for your insights. May I ask why you sold your condo?
I’m on strike and will NEVER sell until the ridiculous 5% selling commission goes lower in this day and age.
Good to know about the 1031 Exchange and 250/500 combo!
Prosper has been so simple for me over the past two years. The P2P space is legit. After speaking with them in SF for 7 years now, I finally believe! I know, it’s kinda crazy how long it took, but I’m always super thorough when it comes to money. It’s too important not to be, especially when larger dollars are at stake!
I don’t blame you for going on strike. The commission is really high compared to the amount of work. I was actually considering taking the test for my real estate broker’s license, just as a means to cut the commission in half. They used to let attorneys skip over the RE agent license and sit for the broker’s exam, but the CA realtors must have lobbied hard because now that rule has been repealed. Even attorneys have to prove sufficient RE Agent sales experience before taking the exam. Sufficient experience means nearly full-time RE agent work for a couple of years, which makes it virtually impossible to hold down your regular job as an attorney and qualify for the exam. It’s another scam to keep the realtors employed.
Anyway, the condo’s kind of a long story. It was my first house with my ex-husband in a very cheap neighborhood. When we divorced we tried unsuccessfully to sell it just as the market was starting to tank. I finally refi’d and bought him out of it at a $280k value. So I figured I would rent it out for almost 3 years and wait for the prices to recover and then unload it. The market dropped all the way past that to $180k afterward. Ouch.
The condo HOA was a nightmare since day 1. Seriously, seriously bad. (For example, they stole my satellite dish off the side of my condo, even though I had gotten a declaratory ruling from the FCC–yes, that FCC–that I was allowed to keep it there. No lie.) Dues went from $140 per month to $331 in the span of about 5 years. The neighborhood REALLY went to crap in the housing market crash, and about 25% of the condos were vacant/foreclosed or rented to really crappy people. It had a flat roof that leaked for 8 years and miraculously stopped leaking for the 6 years I rented out the condo, but given the crappy design of flat roofs in general, was bound to start leaking again and become a hassle. The condo was built (poorly) in the 70s and had started to settle, so all of the metal windows turned from rectangles into parallelograms and they didn’t really close all the way anymore, and I didn’t want to go through the HOA approval process and expense of switching to new vinyl windows.
The condo was slightly cash flow negative the whole time I owned it, but thankfully I have a good job so I could cover it. After 3 years of waiting, the market still hadn’t recovered and it was still upside-down in equity. Crap. FINALLY, last July, six whole years after moving out of the place, the prices got back up to about $280k. With the Fed poised to raise interest rates any day now, and knowing that housing prices typically drop when the interest rates rise, I didn’t want to get stuck in a negative equity situation again.
I considered a 1031 exchange, but ran the numbers on getting a bigger loan to replace the condo with a rental SFR, and the lending/cash flow numbers just didn’t pan out. I could have traded it for another condo, but considering the transaction costs, that wouldn’t be worth it. I decided to just unload it, pay down my house quickly (I refi’d for a 10 year now and it should be paid off in 8) and get another rental property later or invest in other things (real-estate based or not). I’ve got other real estate investments, including part ownership in a 22-unit apartment building and part ownership in a few mobile home parks, so this condo was just something I needed to get rid of, both financially and mentally.