Market uncertainty and capital gains

[Michael Burgoy]

My wife have been living in one of our rehabbed homes in SoCal for about 8 months now as our primarily house. The house has about $450k in equity and with how crazy peaked out the market is right now we are thinking the smart move is to sell ASAP, cash out and rent during the correction. My question is how does the capital gains work on something like this? We have about $200k in rehab and accusation costs and have lived in the house for 8 months as our primary. I've heard the capital gains are prorated during the 1st 24 months. 

On a 2nd note, our original plan was to live in this house for at least 24 months (avoid capital gains) and pull a large line of credit to leverage the equity so we can strike when the market crashes to buy more foreclosures. The house is located in Irvine, CA and currently around 1m value, curious to hear what you guy's would do in this situation? 

[Michael Plaks]

@Michael Burgoy

Equity has nothing to do with taxes. What matters is the full purchase price before considering financing. If you purchased it for $500k (including down payment and mortgage), then put $200k in rehab, it means you put $700k into the property for tax purposes and are looking at a $300k capital gain if you sell it for $1M. (Less than $300k actually, because of closing costs on both ends and other costs you may not have included.)

If you owned the house for less than a year before selling, the gain will be taxed roughly at your tax bracket rate for both Federal and CA taxes - a very high cost. After 1 year of ownership, the rate will drop to a much better long-term capital gain rate.

For the $500k gain exclusion, you normally need to wait 2 years from the date you moved in. Proration that you hope for is not automatic. It only applies if you sold the house for the reasons outside of your control. For example, job or health change. Here is an article that gives some examples: https://www.journalofaccountan...

Simply deciding to sell to cash out on the high market is not a valid reason for the prorated exclusion. However, Covid throws a twist into that. Maybe you could spin the situation where it would fit the somewhat vague definition of "unforeseen circumstances." Consult a good real estate tax accountant to examine your situation. There are more factors to consider, too, for example other personal residence properties you have sold or might be selling.

If the prorated exclusion does not apply to you, then you may be able to defer your taxes using a 1031 exchange or a Qualified Opportunity Zone Fund reinvestment. Both are complex tax strategies warranting professional help before you try either one.

Finally, I share @Christopher Smith's reservations about market timing, in general and especially under the current crazy uncertainty. Remember that this is not only a tax/financial decision but also a lifestyle decision. Owning v. renting has a lot of pros and cons beyond pure math.