thinking about the "2 in 5 capital gains" rule Bushwick/ BedStuy Brooklyn

[Anthony Gallagher]

Hi BP folks!

We have a Bushwick-BedStuy, Brooklyn double duplex / 2 family close to the Halsey Brown line stop.  It is fully rented and cash flows 3k+/month. We bought in 2013 for $800k, renovated in 2016, refi'd & moved out  Jan 2021 and bought in L.A.  For the 2021 refi, the property appraised for $1.7.  We still have about 50% equity in the property at 3.25% interest rate which is now considered an investment property.  It cash flows about 3k/month.   

At this point we're considering our options to take advantage of the "2 in 5 rule" to capture max capital gains which would mean selling in this depressed economy OR to choose to hold for a much longer term to capitalize on the long term asset appreciation, rental income and potentially maxxing out the FAR but with the management, maintenance and developing headaches.

 Kind of a long winded question but considering our options. Thank you!  

[Zeb B.]

I have a bit of experience with this type of situation.

In 2013 I had a single family house that I lived in for 2.5 years and then rented out for the next 2.5 years. Potential capital gains were about 250k so I decided to sell it. I had minimal depreciation recapture taxes to pay and my capital gains were tax free because of the primary residence capital gains tax exclusion. I used the proceeds to buy a new primary residence and two new rental properties.

I'm currently wrestling with a similar set of circumstances on a single family house that I lived in, renovated and added an ADU to. The mortgage rate is 3%, and because of the low mortgage rate and large amount of equity I have in the property, it is cash flowing about $3k/month. I recently moved out, so my 3 year clock to sell and take advantage of the primary residence capital gains exemption just started.

I think the "right" answer depends a lot on what your goals are and what you would do with the proceeds from the sale. 

If you are single, 250k of capital gains are exempt for taxation, if you are married it would be 500k. With a 15% or 20% long term capital gains tax rate, and a 500k exemption, selling within 3 years "saves" you $75,000-100,000 compared to selling farther out in the future.

If your plan is to own that property or a similar rental long term, then the transaction costs from selling that property and buying a similar would probably eat up most of the tax savings. You would also still have a tax bill for depreciation recapture and any gain above your exclusion amount (250k or 500k). 

However, if you do a 1031 exchange with just the right amount of "boot" I believe you could sell the property, pull out 250k or 500k in equity by buying a less expensive replacement property, and use the primary residence capital gain exclusion to avoid capital gains taxes on the 250k or 500k you pull out. However, you are still incurring transaction costs and locking in a much higher mortgage rate on the new property. Unless you have some other factors that make you want to exchange properties or you want to pull money out to use outside of real estate investing, I don't think it is worthwhile to sell the property just to take advantage of the capital gains exclusion.

If you want to pull money out of real estate investing and put it to use elsewhere (i.e. stock market investing or buying a new primary residence) then it probably makes sense to sell while you can take advantage of the capital gains tax exclusion.

If you are going to keep the money in real estate it probably makes sense to hang on to what sounds like a great property and keep the low mortgage rate.

If you want to keep the money in real estate but don't want to own that particular property anymore, or if you would like to increase the leverage on your real estate portfolio, figure out what your tax bill would be from selling. If the tax bill from selling (capital gains in excess of the exclusion + depreciation recapture) is fairly high, consider a 1031 exchange.