Move back in to capture "2 out of 5" possible?

Question

My wife and I lived in a house from March 2016 to September 2018 (almost exactly 18 months to the day). We then rented it out after we relocated across town. If we move back in for 6 months are we able to avoid the capital gains?

From reading other forums I understand it is not necessary to have exact dates and/or proof of those dates. I just wanted to ask about my specific situation since it seems like the posts I came across no one moved back into their property to capture the full two out of the last 5 years.

Michael Plaks · Answer

@Chase Burge

1. You can qualify for the $500k exclusion (assuming you're married) by moving back into A. However, it will be a partial (pro-rated) exclusion because it was a rental property in between your two periods of occupancy. It's an often overlooked rule called "non-qualified use", and it was discussed on this forum in the past. You can search for the older discussions and examples.

2. You can qualify for the $500k exclusion on B by either living there until the 24-mo mark or by having a good reason to move out. For example, a job-related relocation will qualify you for a partial exclusion.

3. You cannot do both. Need to have a 24-mo gap between the two sales, unless you have a good excuse to move out.

4. The high value of A is not an obstacle to 1031. You can exchange A into multiple Midwest properties. Or you can exchange into 1 property plus a passive investment. Talk to @Dave Foster or @Bill Exeter about your 1031 options.

5. I cannot really advise you without knowing a lot more about your situation, but you might be able to accomplish your goals by doing a 1031 on A and then waiting until you hit 24 months in B to utilize the exemption.

Dave Foster · Answer

@Chase Burge, Isn't March 2016 - September 2018 30 months?.

You could indeed move back in.  At the worst you would have some depreciation recapture and possibly a proration for the time it was a rental since you actually converted it to a rental and now would convert back to primary (not certain about that one).  But that's the worst.  Yes sec 121 would be available to you.  Sub point A isn't new it simply means that you cannot do a sec 121 exclusion more than once every two years.

Clayton Mobley · Answer

To sum up, my revised strategy recommendation is this:

• Stay in Prop B for another 8 months to qualify for the 121 exemption. 
• Meanwhile, look for solid cash flow properties in the midwest to prep for a 1031 exchange
• Get yourself a Qualified Intermediary before you go to market with your SD prop
• 1031 exchange your SD prop into a portfolio of cash flow props in the midwest. Same amount of debt (more or less) but with positive net income each month, greater diversification, and a spread out tax bill if you do decide to sell any of the props outside another 1031 down the road.
• Sell Prop B, take your 121 exemption, use it to buy your new home in the midwest

Chris Eidson · Answer

@Bill Brandt @Dave Foster

Thanks for your input.  I didn't realize there would be a proration.  Initially, from following the thread, I was under the impression that both my wife and I could take advantage of sec. 121, because we owned these properties individually prior to our marriage.

Not much savings if I can't take advantage of sec. 121.  I do realize a 1031 is an option, but I was looking for a little more flexibility in my reinvestment options.

Clayton Mobley · Answer

@Chase Burge yes, as long as you have not taken the Sec 121 exemption on the sale of another property within the past two years, you should be able to move back in for six months or more and then be eligible. The Sec 121 exemption does not require that the 24 out of 60 months be consecutive, nor that the 24 months of living there be the same period as the 24 months of owning. For example, if you rented it from someone else from 2015-2017 and then bought it from them, owning from 2017-2019, then you meet both tests with different periods.

Since it sounds like you lived in this house (A) for 18 months, then moved to your current house (B) while you rented out A for the past 16 months. If you sell A now, your lookback period (60 months) is Feb 2014, if you move back in for 6 months and then sell, it's Aug 2014. Either way, your 24 months of living (and owning since they do coincide in your instance) are within the 5 year lookback period (18 months in A + 16 months in B + 6 more months in A = 40 months total, less than 60).

Dave Foster · Answer

@Chris Eidson, Yah I think @Bill Brandt hit it on the head.  There's no problem with doing both.  Your wife could sell now and exclude the entire first property.  Either way though for you you're converting a rental to primary and that means a proration that may not be worth your while.

Another option would be to do a 1031 on your property at any time.  Instead of deferring part and paying part you would defer all and get a cash flowing asset in return.

Chase Burge · Answer

@Clayton Mobley thank you so much for you reply, it was very helpful. My end goal is really to acquire properties in the Midwest (where they cashflow much better than here) and move there permanently. I want to avoid paying a large amount of my capital in taxes so that I can move it into more properties in the Midwest.

Property A is here in San Diego and I break even with it and am mostly riding the appreciation wave right now. Market rents don't support a raise in rent to support the fee of a property manager if we leave the area. Property B we did a live in renovation and created a good amount of equity that we are looking to recover.

Property A would be a challenging 1031 exchange because it is valued at $720,000 and getting a property of equal or greater value in the Midwest is honestly a little daunting because of the size that would be. We would have less than 20% equity so using those gains as a down payment on that property of equal or greater value would not work.

@Dave Foster, sorry for the confusion. That was a typo. We moved out in September of 2017.

Bill B. · Answer

@Chris Eidson

Chris, quick question:

Do you want to move back in to it? Is it a hassle? It looks like if you sold you’d owe 15% capital gains on $50k, or $7500. If you move back in and get your 2 out of 5 years, you’ll avoid taxes on 40% of that gain and you’ll owe 15% on $30k (unless you stay longer) and owe $4500. So you might be doing all this moving and living there to save $3,000.  And each year pays less. Move there for 4 years and owe taxes on 1/3rd or $2500 so save $5,000 over 4 years.

Account Closed · Answer

@Chase Burge take the pro-rated cap gains exclusion and make your life easier. @Michael Plaks makes a good point here that many failed to mention.

How much in cap-gains tax are you really going to pay if you're (most likely) taxed at a long term cap gains rate of 15% on 25% of your net proceeds. have your accountant give you some more specific advice with the actual numbers in front of them.

Maybe someone with CPA background here can chime in- I'd imagine if it's really a substantial amount of gain on that non-exempt portion of the gain (save realtor fees and closing costs) you can throw that portion alone into a 1031 account.

How much of a capital gain are we talking here?

Clayton Mobley · Answer

@Chase Burge I agree that the 1031 should still be on the table for Prop A. You can exchange into multiple properties and really use the capital you have tied up in a minimally-performing asset to get a nice portfolio going in the midwest. If you have 20% equity, that's about $144K, let's round down to $140k since you said you have less than 20%. I'm not sure about the pricing in the market you're looking at, but here in Birmingham that could be 4-6 down payments on solid B/B+ cash flow properties, netting $250-350 per month (with management and all expenses accounted for).

To make the 1031 work, you would need to replace the rest of the value with debt (or extra cash if you have it, but always you must have equal or greater equity AND equal or greater value to defer all taxation), but rather than having one big loan on a prop worth $720k, you'd have 4-6 smaller loans on properties that produce positive income (even with management). Again, this is based on numbers here. I assume if you're looking at a specific market in the midwest for investment (not just to live) then the numbers are similar or better.

My point is that if you are looking to make this midwest market your new investment market, you could take that SD property and turn it into a portfolio fairly easily, deferring taxation along the way.

I'd say it's in your best interest to explore the 1031 option more closely. The longer you hang onto the SD property as a rental, the greater your depreciation recapture tax bill will be when you sell ( you can wrack up a hefty sum pretty quick on a prop of that value). So whether you do it now or later, a 1031 is going to be (in my opinion) the best option. Yes, exchanging into multiple properties takes more legwork and you need to be aware of some timing constraints, but it's definitely doable. What's more, divvying up that value of that SD prop into multiples in the midwest will also divvy up your tax burden, so that if you sell one of the midwest props outside another 1031 exchange (although I generally recommend just doing 1031s until you die) you won't be liable for the full tax bill that would be due if you sold the SD prop right now, just a prorated portion.

Move back in to capture "2 out of 5" possible?

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