Tax implications of turning primary residences into rentals?

Question

My wife and I are looking to buy our third property. Our first is a STR in a great market and is starting to cashflow. We bought it as our first property before buying our primary residence. We now have a primary residence as a house hack with a STR in-law suite that has done well enough to cover most of our mortgage. We are looking to rinse and repeat, and buy a third property that will be our next primary residence with again a STR in-law apartment in the house. We've lived in our current house long enough that I don't think we risk anything with our mortgage in turning our home into a long term rental when we move out and we can set aside the discussion around challenges with our debt to income ratio, the down payment advantages, and if the numbers work on the specific property. From what I can gather, there are lots of opinions on whether it's a good idea or bad idea to turn your current home into a rental property. I want to avoid that discussion.

What I am interested to learn is if there are any tax disadvantages or a blind spot that I am not accounting for in the plan to buy a house hack, move out and turn it into a rental, then buy the next house hack?

I've learned that you get a tax exemption for capital gains up to $500k for our joint return when you sell a primary residence. In this case, we wouldn't be realizing the gains from the sale until much later. I believe we could move back into a property for 2 years out of the last 5 before selling it to get that same advantage. Is there something else I am missing? Is it foolish to lose out on the tax exemption and take the money now (maybe in opportunity cost) by leaving the property as is and keeping it as a rental, as long as it cash flows and isn't a headache?

I haven't seen much on this topic. Curious if anyone has any insight.

Thanks!

Wayne Brooks · Answer

@Ethan Fischer @Jori AndersonClose, but not quite…

You get the full 121 exclusion if you occupy for 2 years and Then turn into a rental for less than 3 years (you occupied for at least “2 of the last 5 years”).

However, if you don’t get the full exclusion with your plan.  If move out for more than 3 years you have lost the exemption..if you move back in at a later date for 2 years, then your exclusion applies on a pro rated basis…if it was a rental for 4 years, then you move back in for 2 years…only 1/3 of the gain is exempt (2 out of 6).

Jori Anderson · Answer

Hi Ethan,

First I want to say congrats on building the portfolio, especially using the innovative house hacking strategy!

But I want to clarify something; your plan is to pull equity from your primary residence that you currently house hack.  And then buy another property and live in that home for how long, house hack in that residence, move out, and transition from that house hack to a buy and hold strategy, to pull equity from there and continue to house hack again?

There are a few factors to consider-

As you mentioned, if you're a married couple filing jointly you could have tax exemption up to $500,000 if you meet the eligibility tests

If it's the sale of your main home, then you must apply the "facts and circumstances" test...

• The address listed on your:U.S. Postal Service address,Voter Registration Card,Federal and state tax returns, andDriver's license or car registration.
• U.S. Postal Service address,
• Voter Registration Card,
• Federal and state tax returns, and
• Driver's license or car registration.

• U.S. Postal Service address,
• Voter Registration Card,
• Federal and state tax returns, and
• Driver's license or car registration.

• The home is near:Where you work,Where you bank,The residence of one or more family members, andRecreational clubs or religious organizations of which you are a member.
• Where you work,
• Where you bank,
• The residence of one or more family members, and
• Recreational clubs or religious organizations of which you are a member.

• Where you work,
• Where you bank,
• The residence of one or more family members, and
• Recreational clubs or religious organizations of which you are a member.

Additionally, there are eligibility tests to satisfy and there are 6 steps to this that can be found in IRS Publication 523.  And even if you fail any of those tests, you could still qualify for a partial exclusion of the gain if under certain circumstances (i.e. health related event, certain unforseeable events, or a work-related move)

In short, The exclusion is available once every two years and there is no limit to the number of times you can take it. When taking the $500,000 exclusion, both spouses must meet the eligibility test and resided in the property for the full twenty four months to qualify for the full exclusion.I'm not sure if my explanation made this more clear or more muddy...

Talk soon,

Jori

Ethan Fischer · Answer

@Jori Anderson

We may pull equity out of our current primary residence in Vermont (the house hack), but we may not need to do that to buy our next house. We have been able to save a lot of money while living in our current house hack in Vermont. The Airbnb portion (which is a bed and bath on our first floor with a private entrance) has rented enough to basically help pay our mortgage and housing costs (utilities, small repairs) so we've set aside a large portion of our W2 salaries during this time. So our plan is to use our savings as the down payment for the next property. Given that interest rates have gone up, and we locked our current mortgage in at under 3%, we are hesitant to refinance our VT home when we move out. Instead, we are probably going to leave the equity in, which I know there is opportunity cost to doing this as that capital could be put to work elsewhere, but if we leave the money in and keep our monthly payments at their current rate we will have much better chance of cash flow from renting the VT house when we leave.

Thank you for the thoughtful response. It's incredibly helpful to know the eligibility requirements for getting the exemption. Sounds like there is more to consider than just living in the property.

Ethan Fischer · Answer

@Wayne Brooks thanks for the clarification. Sounds like the move back into a rental property strategy isn't a silver bullet. Wow, that could definitely change our thinking on this slightly. Maybe instead of trying to relocate to save on the capital gains taxes, we could defer taxes with a 1031 or other strategy.

Thanks!

Basit Siddiqi · Answer

1 - You have to figure out what your depreciable basis will be in your personal residence turned rental.2 - You start the clock on when your section 121 exclusion will expire

Martha Nowlan · Answer

@Ethan Fischer my old friend! Reach out and we can chat more. Sorry for the late reply and hope it's still helpful. First off, keep in mind that you can purchase your new home with 3-5% down, so using home equity for the down payment might not make a lot of sense but you'd want to run the numbers with your lender. You can use the STR income for qualifying as long as you claimed the income on your taxes.

Is there a reason you think you'd be selling the property soon? If it cash flows and is in a good market, why not just plan to keep it? If you have it long enough, capital gains won't kill you because you will have made a ton on it. It's really a matter of what your long term strategy is with the property. I can't say this from experience, but I have heard SO MANY times that people wish they had just kept that property instead of selling it. If it works, keep working it and keep it and worry about the capital gains down the road whenever it's time to sell.

Jori Anderson · Answer

@Ethan Fischer Sounds like ya'll have a great plan in place.  And I agree there will be opportunity costs to forgo regardless of which decision you make.  But the key is, which decision allows you and your wife to rest well at night, while still moving towards your goals at a comfortable rate.

And as things are changing it's a good idea to have access to have enough cash reserves on hand so you're not overleveraged and have the ability to pivot as needed.

Keep crushing it, and I look forward to following your journey.

Jarrod Kohl · Answer

The tax deferring option makes sense if you want to sell and not pay on those proceeds. But if you plan on holding it long term since you would have a low interest loan and be cash flowing, I would not let cap gains tax stop you. First of all they would be long term gains if/when you sell and you could also look into doing a 1031 exchange (though there have been talks about killing that program)

Yes you should do long term planning, but maybe just pencil out a few options. If you are cash flowing nicely for 5+ years (including some tax writeoffs for your rental business) its probably worth paying the tax.

Tax implications of turning primary residences into rentals?

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