How to defer/avoid capital gains tax on sold rental property

Question

Hello All. I am new to the forum. Looking for guidance in relation to the sale of my rental property. I became an accidental landlord 3 years ago. I went to work for a company 3.5 years ago and bought a new construction at that time. Before I could move in, I ended up leaving that company and moving back to my earlier employer with in six months.  In all the chaos, I ended up keeping the house and renting it out for last 3 years. I didn't get to live in the house for even one day. Well, the time arrived this year for me when I have to sell this house. So, I currently have accepted the offer but I am concerned that it is going to cost me significantly in taxes. Bought the property for $570K and after realtor commissions and relevant fees, I expect to get $700K. Bunch of it will go away paying for remainder of the mortgage. Rounding for the sake of simplicity to $130K profit, what strategies could I employ to defer/avoid/minimize capital gains tax. I don't want to invest all the money back into another rental property as I need some part of it and that means I can't benefit from section 1031 exchange. I am not an accredited investor either to get to invest in opportunity zone funds. I expect to be in 15% tax bracket for this capital gain which means it will be a fairly hefty tax. Lastly, I do understand that taxes are part of life, and everyone should pay their fair share, but at the same time, I also believe that I am going to be the only one taking care of my own pocket. Thanks for everyone's help in advance!

Brian Van Pelt · Answer

@Pankaj Kumar

You are pretty much SOL. You may want to speak to an accountant.

Scott McIntosh · Answer

@Pankaj Kumar

First of all, congrats on accidentally stumbling into a $130k profit!  That's a pretty phenomenal situation to be in.  Now that you're in that spot, you've got two viable options to defer some/all of your gain.

A.  1031 exchange or partial exchange, with a potential refi down the road to get some extra cash out (as @Dave Foster outlined).

B.  Reinvest the gains (or any part of them) in a Qualified Opportunity Fund.  The fact that you're not an accredited investor may keep you out of certain passive investments in institutional funds, but doesn't disqualify you from the OZ benefits.

I've created qualified opportunity funds for dozens of clients who wanted to actively reinvest their recently realized capital gains in Opportunity Zone Properties or Businesses -- some started their fund with as little of $500 in long-term capital gains and others have had millions of short-term capital gains.  Once the fund is created, it functions largely like a standard real estate investment LLC, with some additional compliance/reporting requirements.  The mechanics are as follows:

1.  Create a "personal captive" Qualified Opportunity Fund (needs to be a partnership or corporation -- not a single-member disregarded entity).  Partnership structure within an LLC generally works best when the plan is to reinvest in real estate.

2. Open a bank account for your QOF, and deposit recently realized capital gains into that account within 180 days of realization (or 180 days of the end of the tax year, if the gains come to you on a K-1).  This triggers the capital gains deferral for you, which your CPA can record on IRS form 8449 using code "z" for the deferred gain.

3.  Find and purchase property within a designated opportunity zone that you'd like to own as a long-term rental, and that needs "substantial improvement."  Substantial improvement is defined as capital investment that doubles the basis in the structure within a 30 month period.  Structure is italicized because you can back out the land value, which helps alot in making the threshold achievable.  For example, if you buy a single-family home in an opportunity zone for 85k and you can reasonably attribute $35k as the value of the lot, your threshold for substantial improvement is capital improvements that result in additions to basis of 85k-35k = $50k. Alternately, if you buy and develop raw land in an OZ, that threshold does not apply.

4.  Find a good tenant, begin collecting rental income, and remain actively involved in your rental property business.  Note that you can use as much leverage in an OZ investment as you like, so in your scenario you could choose to use your full gain to fund a cash purchase and renovation of one property (like the one described above) or to leverage that transaction and buy several others.

5. Attach IRS Form 8996 to the annual partnership tax return for your OZ fund, certifying that at least 90% of your funds assets were qualified opportunity zone property.

6.  Enjoy the OZ benefits during the time you remain invested in your qualified opportunity fund -- capital gain deferral until the end of 2026, 15% reduction in the amount of your deferred capital gain subject to tax in 2026, and a step-up in basis to fair market value at sale, if you hold your interest in the Qualified Opportunity Fund for 10 years or more.

Standard Legal Disclaimer: The OZ Legislation and Regulations are ~250 pages long to date, and additional guidance is still forthcoming.  The description above of the mechanics of an OZ investment was written as a general overview, and is not a substitute for individual legal advice.  Contact an attorney with expertise in structuring Opportunity Zone investments if this is an area you'd like to pursue further.

Dave Foster · Answer

@Pankaj Kumar, Depending on how much cash you need for other purposes you can still do a 1031 exchange.  The requirement to fully defer all tax is to purchase at least as much as you sell and use all of the proceeds to to that.  You can purchase less than you sell and you can take some of the cash for yourself.  But you will pay tax on the difference while sheltering the remainder in the 1031.  It's called a partial exchange.

Or another common solution is to complete the 1031 exchange fully and then after the fact do a refinance to pull the cash out that you need.  When you do it this way the refinance is not taxable.  You get the money you need.  And the tenants pay the mortgage.  Not a bad scenario.

Dave Foster · Answer

@Pankaj Kumar just remember that for investing in an opportunity zone time isn't so critical.  However if you want to 1031 that property then the QI has to be in place prior to the closing of the sale.  So don't let that critical time path escape you.

Alina Trigub · Answer

@Pankaj Kumar

In addition to 1031, you can also look into doing (a) modified installment sale or (b) 1031 into Opportunity Zones Fund.

Theo Hicks · Answer

If you aren't 1031ing into another deal, Only option is to do seller financing or lease option with the buyer. Or not sell the property.

Brent Shields · Answer

The only thing I can think of is if you want to offer make the buyer a loan for part of the money to buy the house,

then you wouldn't have to pay taxes on any money you carried back in the loan.

You said you needed some of the money, so if you wanted to spend $30k and the sales price is $700k

you would loan them $100k then they would get a bank loan for $570k and you would not have to pay any taxes on the $100k until they paid it to you.

Probably not the answer you were hoping for, but it's the only way I can think you can avoid paying taxes on the sale of your house.

How to defer/avoid capital gains tax on sold rental property

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