How One Couple Saved Almost $100,000 On Their Tax Bill: A Case Study

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I just had a very interesting case today that I wanted to share with those of you who have a primary home that you turned into a rental property.

Recently I met a couple who lives in Seattle. The wife has a rental property that she has owned since early 1996 which is located in California.  The property has gone up significantly in value and they were wondering if this is a good time to sell.

After considering all the improvements made over the years, they are still looking at a pretty significant gain to the tune of over $400k.

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The Problem:

A good return on their investment but they were not excited when their CPA told them the taxes due on that would be close to $100,000. The property actually used to be a primary home used by the wife and her late husband. Upon his passing, she moved her and the kids up north to Seattle, kept this home as a rental, and later remarried. Over the years, her CPA has been depreciating the property based on the original purchase price of roughly $200k. With the recent price increases in the real estate market, she is now looking at potentially selling this property to free up some cash. The bad news is that with a big gain on the sale of the property and depreciation recapture, taxes due on this potential sale could be a hefty amount.

The Loopholes

During my conversation with the couple, I zeroed in on the fact that this was a primary home once upon a time. Even though this home has been a rental for a few years, I wanted to look into the possibility of potentially excluding some of the gain from taxes.

Once I dug into the details is when I discovered the potential loophole we may be able to use. You see, California is a community property state which means that assets owned by the husband is generally deemed to also be owned by the wife.

For this particular lady, her husband passed away in 2011 when the fair market value of this property was a little over $515k. Due to the fact that they held title as community property, this meant that when her late husband passed away, their tax basis in this property got stepped up to fair market value on that date. So instead of having her original purchase price of $200k, her tax basis was actually around $515k. This fact alone may wipe out most of the taxes she was looking at on the potential sale of this rental property.

But There’s More…

Once I dug further, I noticed that she still had time to sell this property using the primary home exclusion. This is one of the best perks that the IRS provides homeowners with. As long as you used a home as your primary home for at least 2 out of the preceding 5 years then you may be able to exclude a significant amount of gain from taxes. For a single person the tax-free amount is currently at $250k. For married couples it is currently double that at $500k.

In this particular example, since the new husband never used the rental as his primary residence, the wife should be considered single upon the sale of this property and should have the ability to exclude up to $250,000 of the gain on sale from their taxable income. The only thing that needs to happen for her is that she needs to sell the rental in CA before fall of 2014 to meet the two out of five year rule.

The Result

So based on spending a few hours of conversations and going back through her old records, we determined that she was able to use two very powerful tax loopholes to wipe out most of her $100k tax bill. First, we can use the step-up basis strategy to increase her basis at the time of her late husband’s death. Second, we may get another $250k of free gain using the primary home exclusion. All in all, she may be able to sell her rental property with over $400k of gain and pay as little as $9,000 in taxes. That is a potential tax savings of over $90k as compared to what she was expecting.

The moral of the story is that taxes, as complicated and nasty as it may seem, can sometimes surprise you. There are plenty of loopholes that are available and all it takes is knowing how to use them to your advantage!
Photo Credit: Universal Pops

About Author

Amanda Han

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine,, and Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.


  1. Jennifer Annen on

    I see this many times with people I work with as well. Many of their “tax preparers” do not understand these rules and give very unfortunate tax advice. The same thing happens with stocks and other assets in community or marital property states. Good catch! I’m sure that woman and her husband are extremely grateful to you for saving them all that money.

    • Thanks for your feedback Jennifer. Yes taxes are complicated and it is hard to keep up to date on all the various regulations as well as loopholes. I think the best way to make sure you keep your money is to contact your advisors often whether it is for tax, legal, investment, or business coach. That way they know how to help you with the transaction you have in mind.

  2. I admire your homework and you benefitted your client greatly, however, a simple phone call to a 1031 Exchange Company would have provided you the same answers in ten minutes even if you were NOT going to conduct a 1031 Exchange.

  3. Hi Tom:

    Thanks for your feedback. Yes 1031 is a great strategy but only for those who want to reinvest their money back into another investment property. Also, you would need to be careful on primary turned rental properties as the 1031x does not protect the primary home tax exclusion and thus can end up costing you the tax-free gain of $250k or $500k. Other than that, yes it is always a good idea to work collaboratively with your CPA and the 1031x custodian to make sure that you have the best strategy for your situation.

  4. Amanda,

    We did not know this. Very good tip! Sounds like we can take advantage of this rule for our personal residence when we sell it. Up to $500k of capital gain tax free! Thanks.

  5. Good stuff to know. Once I eventually sell my house then I could definitely utilize the primary home exclusion. Is this $250k tax-free amount based on a percentage of the final sales price or is it just $250k flat-out?

  6. Okay I’ll not rip the guy on the stepup since that isn’t brutally obvious.
    However it is unfathomable that a CPA isn’t aware of the primary home capital gain exclusion.

    Great job in finding all the potential loopholes for this new client for life, but there wasn’t much competition for you! 🙂

    • Agreed! Yes ….I think it would be pretty hard for any CPA to miss primary home exclusion if it was a situation when someone moved out and immediately sold the house. Believe it or not….when people turn primary home into rentals (and especially if they happen to also switch CPAs in between)….this loophole is when it gets missed most often. Their new advisor has to detailed enough to ask some questions =)

      • I guess that I see that happening.

        But I still find it amazing that they would not know enough about her history to not have picked up on that.
        I guess this is where the whole knowing enough to know what your team is doing makes a big difference.

        I would have dumped that guy in a minute since I know enough about the tax laws that I’d have known that would have been the case. Luckily for your client they decided to talk to someone else. I’m sure most laymen just trust their advisor since they don’t know any better.

      • In more expensive areas with correspondingly more expensive homes I have seen where you really need to crunch the numbers to decide whether or not to use URS 121 “Primary Residence” IRS 1031 and do an Exchange.

        I have worked on transactions where the original primary residence was now a rental house was being sold for $1,500,000 or more where the owners only paid $200,000, for example southern California or New York City.

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