Avoiding a 1031 exchange

[Fletcher Caulk]

I bought a townhome with a VA loan in August 2014 and our renters took over in June 2016. We are considering selling this summer, and I am wondering if we can leave the unit empty for two months so we can take credit for living there for 2 years and avoid capital gains taxes. We would not be living there during these two months. Is this legal?

It would cost us about $6k, but that seems worth it to gain flexibility in not having to go through the 1031 constraints. Our equity is about $200k, so we definitely want to avoid a tax bill.

[Dave Foster]

@Fletcher Caulk, Timing can be a bummer.  

I'd think about the paper trail if you choose to defraud.  And it is fraud.  First of all you've announced it here.  Second you've probably changed your drivers licenses, voters registrations, homestead, buying patterns, and tax returns to all reflect your new primary residence and the fact that this is a rental.  

Now all that being said, I spose you could actually move back in and create some documentables for that.  Not sure that's worth the saving.  

Or why not think about a $6K incentive to a buyer willing to work with your 1031 calendar.  A concession like that for a contingency would get some notice.

[Brian Schmelzlen]

To qualify for the Section 121 exclusion, it must have been your principal residence for 2 out of the past 5 years.  However, you are not required to live there for 2 years straight.  It can bookend having renters there, as long as you do truly use it as a principal residence.  Keep in mind that you would still be on the hook for any depreciation recapture.

If you do not qualify for the 2 years, you may be entitled to a partial exclusion depending upon the reason you moved.  I would talk to your CPA about if you would qualify.

Keep in mind though that the tax reform bill Congress is currently considering changes the timing requirements to 5 out of the past 8 years rather than 2 out of the past 5 years, so if that bill becomes law you may not qualify for the exclusion anyways.

[Fletcher Caulk]

@Dave Foster Definitely not looking to do anything illegal, so thanks for highlighting that important detail. 

Also thanks for the idea of incentivizing the buyer, will definitely do something like that!

[Fletcher Caulk]

@Brian Schmelzlen Thanks for the insight into the current tax bill and depreciation recapture!

[Michael Plaks]

@Fletcher Caulk

Before you look into tax strategies, let's make sure you understand capital gains. You mentioned $200k equity - which has nothing to do with taxes upon sale.

You will be taxed on your capital gain - which is calculated as appreciation of the property from 2014 to 2017. I.e. if you bought it for $400k in 2014 and selling for $450k now - you are only taxed on $50k minus closing costs, including commissions. Equity is irrelevant. You may not have as much taxes as you fear.

In addition, you will also have taxes on the previously taken depreciation - which is the case even if you qualify for homestead exclusion. The only way to duck depreciation recapture tax is thru a 1031 exchange. And a 1031 may not be warranted if your expected taxes are modest.

I have couple blog posts on my website that give examples, but BP won't let me link them, so you have to google it.

[Fletcher Caulk]

Ah good point of clarification on the gain vs equity. It was a VA loan so it's mostly gain, small amount of loan paydown.

[Shane H.]

Originally posted by @Fletcher Caulk:

Ah good point of clarification on the gain vs equity. It was a VA loan so it's mostly gain, small amount of loan paydown.

Fletcher, just to clarify I read your post right - you've made $200k in appreciation gains on a townhome in 3 years or so?  I guess my KS mind is blown - there are very little if any appreciation plays here - much less making 6 figures.

I'd have to be even more worried you're making that sort of a gain on a town home that the bottom is due to fall out of the RE market again.