First Step; couple questions

[Greg Rollins]

Hey BP, 

I am stoked to announce that my offer on my first deal has been accepted. It will be a SFR, house hacking deal in San Diego.

My plan is to live in it for about a year, rent the (2)  extra rooms out to help me with the payments, and renovate the home myself to help save money on labor, but to mainly learn as much as I can about the renovation process for my future deals when I will be managing contractors. Then in about a year or so, after I skirt the capital gains tax, sell it with a nice return on my investment, and 1031 the money into another property.

I am a little nervous about the deal because I bought it without seeing it with my own two eyes. I am still currently deployed in the Middle East and won't be home till the fall. The good thing is I have awesome friends who have helped me check it out and I have trust in my realtor team back home. 

Background before the question:The sellers are getting a divorce, so as part of the purchase agreement they asked if they could live in the house up to 30 days after the closing of the deal paying my PITI for that month. I was more than happy to help them with that, being a child of divorce, I know how hard it can be.

My question for all of you is: While I still want to help them, what steps should I be taking to protect my now new asset for that month? Should I make them sign a rental agreement? Renters insurance? What if they hurt themselves? What if they do damage to the house in the process of getting their stuff out during that month? I don't believe that they are bad people, but I believe one should always be prepared for the worst.

If anyone has been in a similar situation or has guidance on how I should tackle this, I would greatly appreciate any/all opinions and comments. Thank you in advance!

Greg

[Clayton Mobley]

@Greg Rollins I'd like to second @J Scott, if you live in the property it is not eligible for a 1031 Exchange, as that must be used only for investment property. The fact that you rent out the other rooms does not make it an investment property, as you are purchased an SFR as primary residence with the intention to rent out rooms for extra income. Those rooms aren't separate living units with unique addresses, so it's one property that you live in, making it not an investment prop.

HOWEVER, if you live there for two years, you could sell and exclude up to $250k of CG, or $500k if you're married filing jointly. So it sounds like that would be the best route for you if you're just wanting the cash.

Please note that if you only live there for one year and then sell, you aren't automatically able to claim a partial exclusion. The Sec 121 exclusion does allow for a partial exclusion of CG if you meet certain requirements. If you *have to* move because of employment changes, are no longer able to pay for the home, or must leave due to other unforeseen circumstances beyond your control, then the IRS may allow you to claim a partial exclusion proportionate to how long you occupied the property (so, if you lived there for 12 months out of the normally required 24, then you'd get the 50% exclusion. If you stayed longer, you'd get more, etc). If you just decide to move after one year because you want to pocket the change, then you likely won't qualify for any exclusion because that is voluntary.

HOWEVER (again), if your timeline is flexible you could do a couple things. You could live there for two years, then move and convert it to a rental (if you don't need the capital from the property to purchase another primary residence). Then, once it is an established rental property (typically this means rented out for a year or more with the intention to hold it long term) the property is considered an investment and would qualify for a 1031 exchange. 

I feel like this is getting confusing so just consider these two facts:

• You have  to live in the prop for 2 of the 5 years prior to selling in order to claim the full Sec 121 exclusion
• You need to have established intent to hold an investment property (not personal residence) for the long term (more than one year) for it to be eligible for a 1031 exchange.

Now consider this strategy:

• You live there for two years (say June 1, 2017-June 1,  2019)
• Move out and convert to a rental
• Rent out for at least a year (June 2019 - June 2020+)
• As long as you sell before June 1, 2022 (five years from purchase in June 2017), your prop still qualifies under Sec 121 for the full $250k/$500k exclusion.
• Because of the long term rental history, the prop ALSO qualifies for a 1031 (regardless of when you sell) as long as you don't move back in prior to selling.

This would leave you a few good options:

• If you like it as a rental because it's cash flowing nicely, great, keep it and let your tenants pay down your mortgage. You'll lose your Sec 121 qualification after June 2022, but if it's a good cash flow prop then that might be worth it, and you can always 1031 down the line.
• If there's another place your money would be more productive right now, you can do a 1031 and defer taxes on the sale, rolling that capital into a better investment prop(s). 
• You can sell it normally (prior to June 2022) and pocket up to $250k/$500k tax-free under Sec 121. 
• It requires some planning and you should definitely talk to a CPA or 1031 pro, but you can even combine the two, thereby allowing you to pocket the $250k/$500k and roll the remaining CG into another investment prop. 
  • For example, assume the property in the example above has a basis of $100k but will sell for $450k. You have $350k in CG, but you only qualify for the $250k Sec 121 exclusion (ie you're single), meaning you'd have $100k in taxable CG if you sold normally. If you sell prior to June 2022, you could take that $250k under Sec 121 because you lived in the prop for 2 of the last 5 years, and then roll the remaining $200k (basis + additional CG) from the sale into another investment prop(s) via a 1031exchange. No taxes due, a good amount of cash to play with, and a brand new investment property (or more!). 
  • Here's an article from a great Qualified Intermediary who's active here on BP that explains the combination of Sec 121 and 1031: http://www.exeter1031.com/article_overview_1031_12...

If your goal (other than learning the ropes of rehab) is to leapfrog this prop into something of higher value for investment purposes, then I'd recommend moving out as soon as possible to get your rental history started so you can qualify for the 1031. If you're just looking to cash in on a rehabbed prop, like a prolonged flip, I'd recommend sitting tight for the full two years before selling. If you want to have both options and are cool with holding onto it for 4-5 years, then consider the above strategy which gives you multiple choices.

Best of luck!

Clayton