Capital Gains on Primary that turns into a rental?

Question

Quick question,

If I have a home that I lived in for two years and then moved to another home (while leaving the first as a rental), have I lost the chance to sell the first home without capital gains tax since it's now a rental?

Also, if you move from your primary residence that you had a HELOC on, I would imagine moving does not put the HELOC in jeopardy because the equity is still there? Or since lenders don't like to do HELOCs on investment properties that would be a breach of contract?

Steven Hamilton II · Answer

You have to sell within three years of the day you move out to retain the exclusion. Keep in mind you will have depreciation recapture at the sale.

Dave Foster · Answer

@Curtis H., @Steven Hamilton II nailed it on the cap gains tax free timing.  If you go past that three years and no longer have the opportunity to sell using the primary residence exclusion you can still take advantage of a 1031 exchange because the property is now investment and defer (not eliminate) all gain and depreciation recapture.

Curtis H. · Answer

@Steven Hamilton II

Thanks!

That seems like a very good strategy for building capital over a 10 year period. In my case...

- I bought a beat up home Sub2 in a great area 2 years ago and fixed it up while living in it. I have satisfied the capital gains requirement. It now has $200K equity. Another $50K in remodeling will give me $300K equity.

- I find another beater in a good area and do it again, while renting out the above house for 2-3 years. The cashflow would be minimal, but it would cover the PITI which is my main goal.

- Sell the first house after 2-3 years of renting to avoid capital gains and probably net $350-$400K in profit.

- Rinse and repeat. Now this house I'm in obviously has benefited from the huge appreciation levels we are seeing in CA. So I don't expect those gains on the future homes, but still it will be nice gains.

- Added bonus would be to take a HELOC out on primary residence to buy rental properties out of state

Am I missing something here? If people don't mind moving, this seems like an awesome way to go.

Curtis H. · Answer

@Wayne Brooks

Yep, high school sweethearts and still going strong!

@Steven Hamilton II

Right, the only reason not to hold on to it is if you think there will be a downturn and suddenly that $500K equity turns into $225K equity. If we expect appreciation, like we do, no need to sell. I have heard that when banks expect a downturn, they start freezing HELOCs, so that is one potential risk.

Steven Hamilton II · Answer

I agree on keeping it as long as the appreciation is expected AND you can tap into the equity easily.

Wayne Brooks · Answer

I think your wife is a keeper!

Curtis H. · Answer

@Steven Hamilton II

Ok this is where me and my wife went back and forth trying to figure out which scenario is best. I said after renting our current residence for 3 years (assuming we move to another home) then we probably will have closer to $500k in equity that we can cash out on if we sell it without paying capital gains tax.

Her argument is, well you know California, and particularly this area is only going to be more in demand since the Hollywood industry execs are running out of places to live and they are driving prices up by overbidding. She's right, the appreciation isn't stopping anytime soon, and feels we would be selling too early. In 15 years our house could be worth $1.5m with a simple 500 sqft addition. So I see her point. We struck gold with this neighborhood, why sell in 3 years for $500K profit when you can sell in 12 years for $1.1m profit? If we moved back into the home two years before we want to cash out like @Dave Foster suggested in another thread, we could still benefit from a prorated portion of capital gains exclusion. Meanwhile we can STILL be using a HELOC on the home to fund our rental portfolio. So her question is, if you can tap into the equity using a HELOC, why do you need to cash out? Just keep it as long as you can. I didn't have an answer ready, but said I would research it.

Steven Hamilton II · Answer

I would dump it and move the equity over right away into something new. Make it work for you before any other things can change.

Curtis H. · Answer

@Dave Foster

Good point on the 1031. I wasn't even thinking that way but is another tool to use. Appreciate the tip.

Curtis H. · Answer

Squash the HELOC question , found the answer. HELOC stays put if you move. As long as you own it you are all good.

I still do need advice on the capital gains question though.

Thanks!

Capital Gains on Primary that turns into a rental?

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