Capital gains tax of $250k

[usctrojancpa]

Surprised no one has brought up that a 1031 exchange should be done to begin with to avoid any capital gains

Primary residences and second homes are not eligible for 1031 exchange treatment, only rental properties are. You can convert your primary residence or second home into a rental property for 1 year and then do a 1031 exchange but why do that when you have the $250k/$500k gain exemption.  Exemption from tax from gains > deferral of tax gains

Technically he could get both the $250k exclusion and a deferral for any gain over the $250k by doing a 1031 exchange. The tax code allows you to pile these two benefits together. Mechanics are tricky though and likely not what the OP is trying to accomplish. To do it he would need to do the following:

1) Live in the house for at least 2 of the last 5 years as his personal residence. This allows for $250k in gain to be wiped out
2) Convert the house to a rental or business property and have it sit that way for at least two years. This allows for a 1031 exchange deferring the gain
3) Purchase a like kind rental/business property. This property needs to be of equal or greater value and you must close on the purchase within 180 days of selling the original

Here's a good piece that explains how to utilize both of these treatments in one transaction:https://www.bradyware.com/combine-home-sale-gain-exclusion-with-like-kind-exchange/

Yeah it's very tricky and not for the ordinary person to try to pull off by getting overly fancy.  You might get into a battle with the IRS by taking "boot" from the transaction where they may try to tax you on the partial removal of "boot" funds from the 1031 exchange transaction on part of the non-exempt gain and depreciation recapture. Not worth the squeeze in my opinion, I've dealt with the IRS on my commission rebates and it wasn't a fun process because you don't deal with the sharpest tools in the IRS shed on individual audits.

When you say IRS on commission rebates you mean paying outside of escrow and filing the rebate as "unreimbursed business expenses" on Schedule B? This is how I handle some of my transactions but I am lucky to not be audited yet.

No, I mean by listing my rebates on Line 2 (Returns/Rebates) on my Schedule C.  My rebates are 6 figures so it stuck out to them like a sore thumb and hence why they've been auditing me.  I just pull out a schedule of all my rebates along with the closing statements and cancelled check copies to prove out the rebates.  Just a pain in the ass to deal with and a complete waste of time.

 

[usctrojancpa]

Surprised no one has brought up that a 1031 exchange should be done to begin with to avoid any capital gains

Primary residences and second homes are not eligible for 1031 exchange treatment, only rental properties are. You can convert your primary residence or second home into a rental property for 1 year and then do a 1031 exchange but why do that when you have the $250k/$500k gain exemption.  Exemption from tax from gains > deferral of tax gains

Technically he could get both the $250k exclusion and a deferral for any gain over the $250k by doing a 1031 exchange. The tax code allows you to pile these two benefits together. Mechanics are tricky though and likely not what the OP is trying to accomplish. To do it he would need to do the following:

1) Live in the house for at least 2 of the last 5 years as his personal residence. This allows for $250k in gain to be wiped out
2) Convert the house to a rental or business property and have it sit that way for at least two years. This allows for a 1031 exchange deferring the gain
3) Purchase a like kind rental/business property. This property needs to be of equal or greater value and you must close on the purchase within 180 days of selling the original

Here's a good piece that explains how to utilize both of these treatments in one transaction:https://www.bradyware.com/combine-home-sale-gain-exclusion-with-like-kind-exchange/

You're forgetting one major piece which is the exclusion is prorated based on the number of years it was your principal residence divided by the total time you owned the property. Also any depreciation you took while it was an investment is now taxable.

Example is if you owned the property for 8 years as a rental and moved in 2 years as primary (satisfying 2 of 5 year requirement), you will only get 20% (2 of 10 years) exclusion. This is to combat this sort of loophole.

Actually it goes a little deeper than that...the IRS will want to see the FMV of the home when it was converted from a  rental property into a primary residence to determine the appreciation of the home prior to the conversion (that gain will be subject to capital gains tax along with depreciation recapture tax). The ultimate solution is to keep the home and pass it along to kids/family or just keep doing 1031 exchanges until it is inherited by kids/family. Not many free lunches with the IRS.

 

[ChiKid24]

Surprised no one has brought up that a 1031 exchange should be done to begin with to avoid any capital gains

Primary residences and second homes are not eligible for 1031 exchange treatment, only rental properties are. You can convert your primary residence or second home into a rental property for 1 year and then do a 1031 exchange but why do that when you have the $250k/$500k gain exemption.  Exemption from tax from gains > deferral of tax gains

Technically he could get both the $250k exclusion and a deferral for any gain over the $250k by doing a 1031 exchange. The tax code allows you to pile these two benefits together. Mechanics are tricky though and likely not what the OP is trying to accomplish. To do it he would need to do the following:

1) Live in the house for at least 2 of the last 5 years as his personal residence. This allows for $250k in gain to be wiped out
2) Convert the house to a rental or business property and have it sit that way for at least two years. This allows for a 1031 exchange deferring the gain
3) Purchase a like kind rental/business property. This property needs to be of equal or greater value and you must close on the purchase within 180 days of selling the original

Here's a good piece that explains how to utilize both of these treatments in one transaction:https://www.bradyware.com/combine-home-sale-gain-exclusion-with-like-kind-exchange/

You're forgetting one major piece which is the exclusion is prorated based on the number of years it was your principal residence divided by the total time you owned the property. Also any depreciation you took while it was an investment is now taxable.

Example is if you owned the property for 8 years as a rental and moved in 2 years as primary (satisfying 2 of 5 year requirement), you will only get 20% (2 of 10 years) exclusion. This is to combat this sort of loophole.

Actually I'm not forgetting this piece, it just doesn't apply to the scenario I laid out which assumed the OP used the house as his primary residence (my step 1) and then converts it to a rental (my step 2). See Section 121(b)(5)(C)(ii)(I) which specifically excludes any non-qualified use (rental) for the period AFTER the property was used as the principal residence.

Your scenario is different as the rental years happen BEFORE it serves as the primary residence. So the loophole the IRS is trying to avoid is people getting the primary residence exclusion by flipping a rental into a primary residence. The scenario I laid out is the reverse, someone takes their primary residence and rents it out for less than 3 years prior to selling. In that instance there is no pro-rata calculation.

You are correct that any depreciation taken on the rental is taxable.

 

[lovingit]

What happens when you sell a rental that you haven?t lived in for the past 5 years?  Does all the profits become subject to capital gain tax?

If so, what is the range of capital gains tax? 

 

[ChiKid24]

What happens when you sell a rental that you haven?t lived in for the past 5 years?  Does all the profits become subject to capital gain tax?

If so, what is the range of capital gains tax?

Correct, the gains will be taxed at long term capital gains rate, which varies depending on your tax bracket. in addition, you will pay tax on the recapture of depreciation that was taken on the property at your ordinary income tax rate, capped at 25%.

Both these taxes can be deferred if you do a 1031 exchange by purchasing a like kind property within 180 days of the sale.

 

[lovingit]

So let?s say the profit is $500k after agent fees.  Seller would have to pay $500k * 25% = $125k for taxes?

 

[usctrojancpa]

So let?s say the profit is $500k after agent fees.  Seller would have to pay $500k * 25% = $125k for taxes?

Don't forget CA tax which will be your marginal tax rate and if your income is high enough you'll be wacked with 3.8% Affordable Care Act tax on top of the state and federal tax bill.  Federal long term capital gains tax rates will either be 0% (if your income is under $80k in 2020 if you are married), 15%, or 20% (if your income is over $496,600 in 2020 if you are married). So your long term capital rate could be 37% or so if your income is really high.

 

[ChiKid24]

So let?s say the profit is $500k after agent fees.  Seller would have to pay $500k * 25% = $125k for taxes?

From a federal tax perspective only, it would depend on the amount of depreciation the seller had taken on the rental property, their filing status (single, married filing jointly, etc.), other tax deductions and tax bracket. Here's an example.

House purchased for $700k and rented for 5 years.
Depreciation taken over the time period is $100k
House is sold for $1.1M (after agent fees)

The taxes on the $500k gain ($1.1M sale price less $600k basis) would look as follows:
- $100k depreciation recapture taxed at lesser of 25% or the person's ordinary income tax rate
- $400k long term capital gains taxed at the long-term cap gains tax rate. This would likely be the highest rate of 20%, but could be 15% depending on other deductions the taxpayer might have to lower income

 

[Cornflakes]

So let?s say the profit is $500k after agent fees.  Seller would have to pay $500k * 25% = $125k for taxes?

Don't forget CA tax which will be your marginal tax rate and if your income is high enough you'll be wacked with 3.8% Affordable Care Act tax on top of the state and federal tax bill.  Federal long term capital gains tax rates will either be 0% (if your income is under $80k in 2020 if you are married), 15%, or 20% (if your income is over $496,600 in 2020 if you are married). So your long term capital rate could be 37% or so if your income is really high.

Moral of the story...Don't sell. But then, if you are sitting on >500k gain and make >500k a year...you probably are good with money and would make an optimal financial decision anyways.

 

[usctrojancpa]

So let?s say the profit is $500k after agent fees.  Seller would have to pay $500k * 25% = $125k for taxes?

Don't forget CA tax which will be your marginal tax rate and if your income is high enough you'll be wacked with 3.8% Affordable Care Act tax on top of the state and federal tax bill.  Federal long term capital gains tax rates will either be 0% (if your income is under $80k in 2020 if you are married), 15%, or 20% (if your income is over $496,600 in 2020 if you are married). So your long term capital rate could be 37% or so if your income is really high.

Moral of the story...Don't sell. But then, if you are sitting on >500k gain and make >500k a year...you probably are good with money and would make an optimal financial decision anyways.

That's why it's just a personal decision and all facts/circumstances have to be considered before deciding on the best course of action.  But yes, some people made a lot of money holding onto real estate and/or using 1031 exchanges to increase their real estate holdings over time.

 

[Cornflakes]

Holding on to real estate.
Donald Bren.