Continue to rent or sell sooner to claim 121 exclusion?

Question

Hi - I have a rental that I lived in from July 2012-July 2015, it has been rented since then. We are looking for new tenants to move in on 8/1/2017. My question is, if we have tenants in there until the end of 8/2018 and then we decide to sell, are we going to have to pay taxes on the proceeds? I know that the 121 exclusion says we have to have lived there 2 out of the last 5 years, if I understand that correctly then we must sell by July 2018 or we lose the exemption?

If that is the case then we will likely sell now or get the tenant to sign a 9 month lease instead of a 12 month one so we can put it on the market in April of 2018 to sell in time to avoid paying the taxes.

Thoughts? Am I understanding this correctly?

If that is the case then we will likely sell now or get the tenant to sign a 9 month lease instead of a 12 month one so we can put it on the market in April of 2018 to sell in time to avoid paying the taxes.

Thoughts? Am I understanding this correctly?

Dave Foster · Answer

@Gwen St. Pierre IRS publication 523 will walk you through it - here's the direct quote to your question - You owned the home and used it as your main home during at least 2 of the last 5 years before the date of sale.

Should you go over that time frame @Samantha Klein, is exactly right - the 1031 option would still be available to you.

However, remember that even if you qualify for the 121 exemption you will have to recapture depreciation for the rental period unless you also do a 1031.  It may not be much if only 3 years but something to keep an eye on.

Ben Raygor · Answer

@Gwen St. Pierre, you sound like you want to sell the property and no longer manage it due to being 4 hours away.  IF you wanted to consider holding onto it as a rental longer, there is a way you can take advantage of the 121 exclusion and still hold onto the property as a rental.  You could create a Corporation (S or C) and sell it to that entity for the fair market value ($165,000 perhaps).  As an individual, you will report the sale on your personal tax return and take advantage of the 121 exclusion.  The Corporation will have a stepped up basis in the property of $165,000 and will depreciate based off of that.

This is a strategy that is generally used for higher dollar transactions with higher capital gains.  It costs money and takes time to setup a Corporation.  The strategy is an option depending on your cash and financing options too at the time, so it might not even be feasible right now.  But it is definitely something to keep in mind for future primary residences that may result in larger capital gains but would still make good rental properties.

Bill Exeter · Answer

Hi @Gwen St. Pierre,

You are correct in that you have a limited time frame here. As others have pointed out, you must be able to say that you have owned and lived in the property for at least a total of 24 months out of the last 60 months (2 years out of the last 5 years). The day that you moved out of the property commenced a three year window in which you have to sell and close on the sale of your property in order to qualify for the 121 Exclusion. You would have to actually close on the sale of your property before the end of the three year window in order to qualify for the 121 Exclusion.

The key point to remember is that the 121 Exclusion is tax free (except for any depreciation recapture), while a 1031 Exchange is only tax-deferred. If you have a sizable capital gain, you need to take a serious look at the 121 Exclusion before you lose the ability to lock that in on a tax-free basis. If the gain is small, and you are happy with the property and its performance, I would just hold on to the property at this point in time and consider a 1031 Exchange in the future, if warranted.

Once you have crossed the three year window your property will be exclusively rental, investment use property, and you would qualify for 1031 Exchange treatment.

Samantha Klein · Answer

You could also use a 1031 exchange if you go past the time limit. If your worried about it and want to cash out, you should sell now. You don't know how long it will take to sell either.

Gwen St. Pierre · Answer

@Ben Raygor - thank you. I love that creative way to do both and will definitely keep it in mind for larger capital gains situations in the future.

Mindy Jensen · Answer

@Gwen St. Pierre , if your home doesn't sell in time, could you move back in to make up the difference and avoid the taxes? I'm not super familiar with the Wilmington market, but I believe prices have increased since you purchased. The 1031 Exchange delays taxes, 121 erases them - if you follow the rules. I'd rather not push them down the road if I can avoid them altogether.

Gwen St. Pierre · Answer

Good stuff - thanks for pointing out the difference between tax free and tax deferred @Bill Exeter - that is not a small thing to overlook.

Gwen St. Pierre · Answer

Thanks @Dave Toelkes

I file jointly and we were in the 15% tax group last year but barely....I think we will go up to 25% next year.

We paid $130k for the property in 2012 using a USDA loan with 0% down and an interest rate of 3.5%.

We think we can get $165k for it now and we don't have any additional mortgages or lines of credit on it.

Honestly, I think our COCR is better than our monthly cash flow since we put no money down. If we DON'T account for Cap ex our monthly cash flow is $492. I just now analyzed the property properly (using BP calculator) and if I put in the Cap ex correctly it is a negative cash flow of $-132.67. Now, this is including paying a property management fee to ourselves, but even without that it would be break even.

We put in a new HVAC this past winter and flooring in 2014, but otherwise have done very little and the place will need some big ticket items soon like roof, kitchen and bathroom.

I should say we bought this as a primary we never ran the numbers for using it as a rental - we just wanted to get started in REI so we turned it into a rental when we bought our next property. I feel like I'm talking myself into selling the more I type....get the good cash on cash return out and use it to get a property better suited to renting. Also, we moved in April so the property is now 4 hours from us and we are managing it ourselves from afar.

Dave Toelkes · Answer

Have you calculated your tax savings by selling under the 121 exclusion?  If your capital gain due to appreciation is not that much, if you are in the 15% marginal tax bracket,  and if the rental income is giving you a positive cash flow, is there a compelling reason to sell at all?

To make an informed decision, you need to determine how much tax you would pay on the sale of an investment property.  The depreciation recapture will be the same for an investment sale and a primary residence sale, so, the discriminating factor here is the amount of long term capital gain due to appreciation you have and how much tax you would pay for your marginal tax bracket.  Let us know your numbers and we can give you more meaningful feedback.

Gwen St. Pierre · Answer

Thanks! Do you know if the 121 exclusion would require the sale have to close before the time limit is up or just be under contract?

Continue to rent or sell sooner to claim 121 exclusion?

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