Good news! You bought your house, years ago, for what seems like a song today. You’re amazed you could sell your house for SIX times more than what you paid for it!!! You’ve never felt richer! You head to your accountant with the good news. Your accountant tells you that at the sales price you think you can get, you’ll have an enormous capital gain tax to pay. Suddenly, you’ve never felt poorer!
Your accountant has provided you with a few options to avoid paying the capital gain tax.
One of the options is to rent your house out for a couple of years and wait to see if there is a downturn in the market so you’ll pay less in capital gain tax. Sure, it's a gamble that comes with a steep price if you rent it too long. How? If you rent it out for more than three out of five years, you will lose your $250,000 capital gain tax exemption for singles or $500,000 for joint owners. To keep you exclusion you will need to sell before that point or move back in to ensure you meet the occupancy and use rules.
If you want to forgo the capital gain exclusion, you can defer taxes through a 1031 exchange and take on managing investment property from here on out.
But what if you need the money to move into another residence?
First, let’s backtrack a moment. I’ll assume that you kept track of all of your enhancement expenses (not maintenance costs), any assessments charged by your HOA, any qualifying closing costs and your cost basis. Did you keep all your receipts? If not, talk to your accountant to see if you can recreate proof of expenses. It could help bring down the amount of capital gain tax you owe.
The capital gain tax is 15-20%, dependent on your income level. If your current income brings you to a higher tax bracket, would post-retirement income bring you to a lower level? Would deferring social security or 401K income until after age 70 make sense? Talk to your accountant as the tax on your gain has to truly warrant this type of deferment.
However, if these options don’t offer relief, you are faced with some tough decisions. If you explore renting your house out, ask yourself the following questions:
- Are you prepared to take on the job of being a landlord?
- If a tenant is rough on the house or something needs fixing, are you prepared to deal with that expense? Keep in mind, this will be an out-of-pocket and with a tenant in place, you’ll need to fix it immediately. Can your cash flow or reserves, handle this?
- If you are out-of-the area, can you find a reliable property manager to find tenants, manage property, fair housing laws and deal timely with issues? If a vacancy occurs or your tenant stops paying, can you still keep the property afloat? IRS deductions vary depending on whether you actively or passively manage the property.
- If you want to preserve your capital gain exclusion, are you prepared to sell in three years regardless of the market's position? Or, are you prepared to move back in?
- If you decide to do a 1031 exchange, do you really want to deal with the requirements of a 1031 exchange? Strict guidelines must be adhered to in order to continue tax deference. Perhaps only a partial deferment of excess capital gain into 1031 exchange?
- Are there other options to consider? We'll explore this question in a future post.
I know most would-be- retiree/landlords haven’t thought through all of the legal and tax ramifications. Many weren't even aware of the capital gain exclusion, since they bought so long ago. If you bought before 1998, you may be thinking you have a one-time capital gain exclusion of $100,000, over the age of 55. The Tax Relief Act of 1998, truly addresses gains to be made in this peaking market. No other asset class has such a tremendous tax exclusion.
Maybe, that $250,000 tax exclusion per owner, might just be enough. Maybe you won’t mind paying the tax on any gain over your $250,000 or $500,000 exclusion. Is the money in hand, worth it? Your accountant should help you answer that question.
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