I have kind of a sticky situation. My wife and I have jointly owned our primary residence (let's call this property A) since 1996 and have built quite a bit of equity in it. We recently decided to purchase a bigger place (let's call this property B) and rent property A. I have three tax related objectives in this transaction:
1) Protect my capital gains tax exemption (part 121 I think it's called) that I have built to this point on property A should I decide to sell it at some point after it has been a rental (not our primary residence) for 3 years.
2) Get my basis on property A as high as possible to maximize the tax benefit from depreciation. This would also help with objective 1 in that it would "reset" the capital gains basis.
3) Refinance property A and use the proceeds to purchase our new primary residence (property B) and have the interest on this new mortgage be expensible, that is, be able to treat it as an expense to offset the rental income.
I've talked to several people and all tell me I'm essentially screwed on this. They say that my basis must be calculated from the original purchase price plus capital improvements and that if I use the proceeds of the refinance for purposes other than directly related to the rental (property A) then I won't be able to expense the interest OR deduct the interest.
What really gets me is that if I were to SELL property A and use the proceeds to purchase property B, and then go out and purchase an investment property of the same value as property A (I could even repurchase property A for that matter) and take a mortgage on it, I would essentially achieve all three objectives. The problem with this is that first, I would rather not sell in this market and second, I like property A and plan to turn it into a part time vacation home at some point in the future and maybe even turn it back into our primary residence once the kids are grown and out of the house.
Can anyone think of a way to achieve these objectives without selling property A? Is there some sort of way to do an "arms length" transaction in order to achieve this? I'm not trying to beat the system here, I'm just trying to stop it from beating me.
Loveland, CO · Member since 2008 · 1k+ posts · 123 votes
18y
First; I curious as to where you live that you can get a SFH to cash flow?
You basis is your basis, nothing other than capital improvements will change that.
If you want to keep property A, why not do so? IF IT WILL CASH FLOW. Then just get a first mortgage on property B.
I just re-read your part 1 again. I don't know if you wrote it in a hurry or if you misunderstand the IRC. If you sell it after it's been a rental for 3 years you'll lose the section 121 exemption.
Your post almost makes it sound as if you want to borrow money for the sake of borrowing money, ie; to have more interest deductions. Don't do that!
Tell us; 1. if property A will cash flow, and; 2, if not why you want ot keep it, and; 3, what makes you think selling A, buying B with a mortgage and then buying C with a mortgage (or rebuying A at an inflated price???) is a good idea from an investment standpoint.
Accountant · Newtown, CT · Member since 2008 · 123 posts · 34 votes
18y
Originally posted by "hjorgan":
1) Protect my capital gains tax exemption (part 121 I think it's called) that I have built to this point on property A should I decide to sell it at some point after it has been a rental (not our primary residence) for 3 years.
You would still have a portion of your gain qualifying for the exemption, but the amount that is allowed or allowable (which you would take) as depreciation expense would not qualify for the exemption. You will need to show that you owned the property for 2 years in the last 5 year period. If that is the case, which it would be if you sold it before 3 years after you moved out, then you would figure the gain like this.
Total gain - depreciation - exemption = capital gain recognized
The depreciation expense taken on the home during rental period will be recognized as a capital gain. If you have a gain that is large enough to absorb the depreciation taken and the $500K exemption, then you would have more capital gain to recognize in addition to the depreciation taken while you rented the home.
If you moved back into the home after you rented the property to re-establish Property A as your primary residence, then you would not have to worry about the depreciation taken as a capital gain and it would be a straight gain minus exemption calculation.
If you did not move back into the home and sold it after the three year period of renting the home, then the exclusion is lost. (all cash already stated)
Originally posted by "hjorgan":
2) Get my basis on property A as high as possible to maximize the tax benefit from depreciation. This would also help with objective 1 in that it would "reset" the capital gains basis.
The only way you can "reset" the basis is by selling the property. The basis is your purchase price + upgrades/improvements. No way to arbitrarily increase basis.
Originally posted by "hjorgan":
3) Refinance property A and use the proceeds to purchase our new primary residence (property B) and have the interest on this new mortgage be expensible, that is, be able to treat it as an expense to offset the rental income.
Any mortgage interest expense you have on rental property will be a deduction. Plain and simple.
Originally posted by "hjorgan":
I've talked to several people and all tell me I'm essentially screwed on this. They say that my basis must be calculated from the original purchase price plus capital improvements and that if I use the proceeds of the refinance for purposes other than directly related to the rental (property A) then I won't be able to expense the interest OR deduct the interest.
Well, several people are correct that your basis is purchase price plus improvements, but that is all they are correct on in your statement. If you have a refi and take the proceeds and shoove it up your "watch your mouth!" or just burn it in the fire place, it won't matter. You will get a deduction for any mortgage that you take out on rental property. Business expenses need to be ordinary and necessary to be deductible and a mortgage interest falls under that category.
Originally posted by "hjorgan":
Can anyone think of a way to achieve these objectives without selling property A? Is there some sort of way to do an "arms length" transaction in order to achieve this? I'm not trying to beat the system here, I'm just trying to stop it from beating me.
Well, hold on to your hat, here we go!
First you need to set up an LLC. Have yourself, your wife and maybe your children as owners too. (to be able to pass value down to them that won't fall into your estate at time of death, an estate planning tool). The LLC will acquire PROP A from you and your wife at the FMV that is reasonable. You get to utilize your home sale gain exclusion and the LLC will have a basis equal to the purchase price. The LLC will obtain a loan (may be only 60% or up to 80% LTV, but maybe that is enough to achieve your goal and you may have to set up an owner financed 2nd mortgage too). The cash proceeds will be paid to you and your wife after your liens are satisfied at the closing and then you will have those proceeds available with your personal financing to purchase PROP B.
There you go. Prop A is still in your control and ownership, has a higher basis and is outside of your personal liability. You used your gain exclusion to get a higher basis in the property to depreciate and the capital gain going forward will be determined using the new adjusted basis. The proceeds from the sale of A to the LLC will be used to purchase Prop B. You will need to make sure you have all i's dotted and t's crossed to effect an actual sale.
This may be viewed as aggressive by some and just normal by others but depending on how it is set up and how the transaction is handled will determine the substance over form issue with the IRS. If you show that your only motive is tax evasion or tax reduction, then the IRS can recharaterize the transaction to how they deem it should be. That goes for any transaction, not just this one discribed here. If you put your children in the LLC, then you have an additional point that you are utilizing this as an estate and wealth preservation plan so they can pay for their own college education in the future and that current tax reduction is just a byproduct of the overall goal of planning for the future.
As always, seek further advice from your local CPA to help guide you.
Thanks for your reply Joe. This is the kind of thing I'm hoping to be able to do. I've consulted two tax professionals to this point and one says that this is possible and the other says it's not since the IRS would say that the transaction was not at "arms length". I think it's time to consult a CPA on this.
I live in CT. Anything will cash flow as long as the income exceeds the expenses, right? That said, my primary concern here is not generating cash flow. There are better ways to accomplish that.
Understood. We're saying the same thing. What I'm getting at is I would like to keep the property but, on the chance that I might want to sell it after it's been a rental for more than 3 years, I'd like to make sure that I've protected the substantial capital gain that I would have if I sold today. Take the gain and exemption now and reset the clock. Then if I sell at any point, the cap gain (or loss considering where the market is going recently) is measured from when I convert it into a rental.
Nope, I need to borrow if I'm going to have both prop A and B. It's just a question of where I hold the mortgage. On prop A the interest would offset the rental income on sched E. On prop B the interest would offset income from my day job (sched A). The end result should be the same in either case EXCEPT, my income is at the point where itemized deductions are being phased out. So, I'm told that putting it on sched E is the way to go (won't lose it there).
My primary concern here is not investment, it's keeping property A and making use of it at some point in the future as a summer home and possibly a primary residence again when we can fit back into it. It's a high-end water-oriented property that will likely hold it's value better than most properties in a down market and appreciate more than most in an up market.
Accountant · Newtown, CT · Member since 2008 · 123 posts · 34 votes
18y
As a CPA, I look at this as a grey area and it depends on how aggressive you want to be and what your situation is. Like I said, you would want to show a more than just tax reduction as the purpose for doing this.