I’m not necessarily complaining about it because bad landlords (and profit-seeking actions that harm renters) have made increasing tenant protection a necessity. $114,000 ($200,000 × 57%) qualifies for the home sale exclusion and is tax-free. Question A property was my principal residence for the first 2 of the 5 years which ended on the date of the sale of the property. This is similar to Scenarios 1 and 2, except the couple rents out the home for 10 years before they move back in full-time. I probably would not have done it. It’s been a (mostly) good experience, but the numbers just aren’t a slam dunk. We targeted holding 80% stocks, 20% bonds in addition to the rental property. So, it’s not a disaster. Unfortunately, in our area traffic continues to worsen and there are no great public transportation options. They sell the property two years later, with depreciation of $70,000 over the rental period. The IRS doesn’t want people abusing the five-year rule with rentals that they move back into just before the sale. In this scenario, we know our housing costs would be much lower: taxes (mostly known), insurance, and a maintenance fund. The home has doubled in value. I plan to share some of the projects we take on and the work we do to bring the place up to par long term. If you moved into the investment property and lived there for 3-5 years and paid off a large chunk off the mortgage you could turn it back into an investment property simply by moving out and renting it to a tenant. The rules are different for a rental, and there is still a lot of misinformation out there. Generally, the law allows an annual depreciation deduction on your rental property and you must reduce the basis of the property by the amount of your depreciation deductions. Fortunately, the house cash flowed immediately. This permits you to defer recognition of any taxable gain that would trigger depreciation recapture and capital gains taxes. Why do you need a financial plan? I am looking for the place then I will invest. Read We Sold Our Home for a Loss – Now What? This reduces the % of the deduction which you are eligible. Factors like depreciation recapture, qualified vs. non-qualified use and adjusted cost basis could make you think twice before moving back into your rental to avoid taxes. However, even with rent increases the property isn’t anywhere near the 1% rule. This is troubling, largely because it’s so preventable. Since the gain is $40,000 and the depreciation recapture of $40,000 x up to 25% is paid first, there is no gain left over that’s tax-free or taxable at capital gains rates. Great! Utility situations depend on what kind of rental you move into and … We could rent and then spend only what we cash flow. There are also a number of things specific (but not unique) to our situation. © 2020 Merriman Wealth Management, LLC. We’ll use the same dollar amounts as above. 221 Principal Interview Questions (for 2021), Wealth Accumulation Phase (Strategies and Examples), Housing is settled (for as long as we want it to be), Cash currently on the sidelines gets back into action, Our annual expenses are lower than they were 15 years ago. Also see Landlord and Tenant Evictions. Required fields are marked *, Bonus: A FREE copy of An Educators Quick Guide to Financial Independence. We’ve paid attention to opportunities around us, but haven’t found anything that is ideal. There will be environmental noise from nearby construction for several years. As outlined above it gives us flexibility. For eight years, we had zero problems with our rental. Of course, they won’t need to be done again for at least twenty years – which is a positive. Rental property is the best option you can choose. The major known repairs have mostly been taken care of. If you live in your home for two years and then rent it out for two years before selling it, you qualify for the full exclusion amount due to meeting the use test by having lived in the home for two out of the last five years before the sale and meeting the ownership test. The more I get into this FI journey, the more I realize that it is not a linear journey. If we sold the house now we would pay full capital gains on the amount the house has appreciated since we have not occupied it for two of the past 5 years. Tenant's Rights When a Landlord Sells the House. We’d have certain and stable housing. As with her work, our rental house is closer to her parents than both our current home and any potential long-term options. The tenants have been great and relatively low-effort. This is largely an ego consideration. However if you have never lived in the property and it was rented out from day one than you will not qualify for the six year rule. Note: You can’t claim a loss for tax purposes if the property sold is your primary residence. Especially into a quality of life decision like housing. Any long-term options would require us to move farther away. We can’t make our final move without significantly impacting TFI’s commute and thereby her quality of life. It was just eight months ago that we made a dramatic housing change – selling our big house in a beautiful location to move into a home less than half the size. Transfer and/or Set Up Utilities. I think you guys are on the right track. Other options like deferring taxes with a 1031 exchange could also be more helpful for managing your tax payment than selling your rental outright. Since 2009, the IRS has required your ownership period to be categorized between qualifying and non-qualifying use. The gain on the sale is $200,000. We wanted the cash available until we decided on our long-term housing plan. Now that we have investigated potential capital gains tax exclusions and issues like depreciation recapture that is recognized first on your rental, we’ll break down how to determine your adjusted cost basis for calculating gains on the sale of your property. You might be considering selling your rental to lock in profits and enjoy the fruits of your well-timed investment, but realizing those gains could come at a cost. We already know the environment is suboptimal for our spending choices. Additional Information Publication 527, Residential Rental Property (Including Rental of Vacation Homes) Category Capital Gains, Losses, and Sale of Home Sub-Category Property (Basis, Sale of Home, etc.). Then, the house will be ready for sale or to go back up for rent once we identify our long-term housing solution. All this has led us to question whether we want to continue doing it in the future. We can never regain that lost opportunity, but we can capture one now. There is no reset of the cost base once you move into a property that originally started out as a rental. Every dollar can help reduce taxes you may owe on the gain one day. In this case, it’s not a financial slam dunk. There are many benefits of moving back into the rental property: It’s amazing how much our life has changed since we started pursuing financial independence. If the residence was used as a principal residence first and then converted to nonqualified use, the taxpayer may potentially qualify for a full exclusion. We still own and operate a short-term rental, but it isn’t a significant portion of our holdings. In some cases, you simply have to give notice – and that notice might be as short as 30 days. Not having a mortgage is going to free up so much cash and investing capital! We’ve loved everything about the change, but discovered that our current location isn’t the right long-term choice for us. We’ll have a locked-in housing plan and the option to sell, rent, or remain in place. When they sell the property, its adjusted basis is $355,000 ($375,000 + $20,000 selling costs – $40,000 depreciation taken). For rental property, the law has additional limits on the amount you may exclude. Additionally, taxable gain on the sale may be subject to a 3.8% Net Investment Income Tax. Since the couple meets the requirements to use the tax-free gain exclusion, we need to break down the gain based on qualifying use and non-qualifying use: Of the $170,000 gain, the first $40,000 is subject to depreciation recapture up to 25%. We know exactly what we need in our living space. After this choice, our annual expenses will be lower than they were early in our teaching career. The first $40,000 of the gain is subject to depreciation recapture at up to a 25% tax rate. Our first home, that has been a rental for the past ten years, was open. My parents own a rental property. We had our regular restaurants, bars where we spent money, and lots of retail choices. I can do most of that, but not in a short time frame due to my day job. It’s always been occupied (no vacancy lasted longer than the amount of time we needed to turn it over.) We cut our monthly housing costs in half, improved our quality of life, and accelerated our financial independence plan. Note: Property you convert to a primary residence that was part of a previous 1031 exchange must be held for a minimum of five years to be eligible to receive any of the gain exclusion. If we were to live in the property for two years, it would give us the ability to avoid taxes on some of the appreciation at sale – but not the full amount. Should we sell, we will pay taxes as part of depreciation recapture. That changed with the last set of tenants. Ultimately, we decided to move ahead despite the concerns. It’s larger than our current space. That opens up a number of options in the future. A 1031 exchange with part of the equity to a more financially efficient rental and take the remainder for a smaller house in a cheaper area. This means the gain is … That will make life much easier in the long term. But in a strained economy with an uncertain future like what we’re seeing in 2020, many property owners are deciding to get out of the landlord gig and offload their rental homes amid falling rent prices in many major cities. Not only to increase your chances of success, but to also minimize potential failures. This is similar to Scenario 2, except the home sells for $395,000 instead of $525,000. The benefit would climb slightly for every year after that. We won’t be forced into a quick choice by a landlord, pressing financial needs, or housing instability. (Yes, we moved from an almost 2000 sq ft house to an almost 3000 sq ft house during our lifestyle inflation phase. Yikes.). This gets tricky since we have to dig into recent changes with the tax code. Check your local rental rules. The opposite is not true. That makes it too much of a gamble. That is – if we choose to rent it out, it must at least cover the costs of our new home. But…if we move in, I can do them over time. Rental Property The IRS imposes special rules on houses that you rent out. All those regulations definitely make it hard to be a landlord. All Rights Reserved. Let’s take a look at some of the moving pieces for determining the taxes when you sell your rental. I mentioned our most recent tenants were hard on the place. Retrieved from https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc-5, S&P Dow Jones Indices. Or, if we choose to sell, the proceeds will be our budget for our long-term home. Five days after closing Kim was laid off her job of 15 years. Homeowners who live in a property as their primary residence for at least 2 of the 5 years preceding sale are entitled to tax-free gains on the sale of the property up to $250,000 for a single owner or $500,000 for a married couple. We could stay here happily for a few more years, but an opportunity appeared when the tenants in our rental property gave notice. For now this is the right choice for us. During the four-year rental period, they take approximately $40,000 of depreciation. Right now, it hits about .5%. The plan to own a rental property might have been the right one at the time. The depreciation you take reduces your basis in the property, potentially resulting in more capital gains when you ultimately sell. Can I still exclude the gain on the sale and if so, how should I account for the depreciation I took while the property was rented? Our downsizing process told us exactly how we preferred to live. 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