How One Couple Saved Almost $100,000 On Their Tax Bill: A Case Study

I just had a very interesting case today that I wanted to share with those of you who have a primary home that you turned into a rental property.

Recently I met a couple who lives in Seattle. The wife has a rental property that she has owned since early 1996 which is located in California. The property has gone up significantly in value and they were wondering if this is a good time to sell.

After considering all the improvements made over the years, they are still looking at a pretty significant gain to the tune of over $400k.

The Problem:

A good return on their investment but they were not excited when their CPA told them the taxes due on that would be close to $100,000. The property actually used to be a primary home used by the wife and her late husband. Upon his passing, she moved her and the kids up north to Seattle, kept this home as a rental, and later remarried. Over the years, her CPA has been depreciating the property based on the original purchase price of roughly $200k. With the recent price increases in the real estate market, she is now looking at potentially selling this property to free up some cash. The bad news is that with a big gain on the sale of the property and depreciation recapture, taxes due on this potential sale could be a hefty amount.

The Loopholes

During my conversation with the couple, I zeroed in on the fact that this was a primary home once upon a time. Even though this home has been a rental for a few years, I wanted to look into the possibility of potentially excluding some of the gain from taxes.

Once I dug into the details is when I discovered the potential loophole we may be able to use. You see, California is a community property state which means that assets owned by the husband is generally deemed to also be owned by the wife.

For this particular lady, her husband passed away in 2011 when the fair market value of this property was a little over $515k. Due to the fact that they held title as community property, this meant that when her late husband passed away, their tax basis in this property got stepped up to fair market value on that date. So instead of having her original purchase price of $200k, her tax basis was actually around $515k. This fact alone may wipe out most of the taxes she was looking at on the potential sale of this rental property.

But There’s More…

Once I dug further, I noticed that she still had time to sell this property using the primary home exclusion. This is one of the best perks that the IRS provides homeowners with. As long as you used a home as your primary home for at least 2 out of the preceding 5 years then you may be able to exclude a significant amount of gain from taxes. For a single person the tax-free amount is currently at $250k. For married couples it is currently double that at $500k.

In this particular example, since the new husband never used the rental as his primary residence, the wife should be considered single upon the sale of this property and should have the ability to exclude up to $250,000 of the gain on sale from their taxable income. The only thing that needs to happen for her is that she needs to sell the rental in CA before fall of 2014 to meet the two out of five year rule.

The Result

So based on spending a few hours of conversations and going back through her old records, we determined that she was able to use two very powerful tax loopholes to wipe out most of her $100k tax bill. First, we can use the step-up basis strategy to increase her basis at the time of her late husband’s death. Second, we may get another $250k of free gain using the primary home exclusion. All in all, she may be able to sell her rental property with over $400k of gain and pay as little as $9,000 in taxes. That is a potential tax savings of over $90k as compared to what she was expecting.

The moral of the story is that taxes, as complicated and nasty as it may seem, can sometimes surprise you. There are plenty of loopholes that are available and all it takes is knowing how to use them to your advantage!
Photo Credit: Universal Pops

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.