Renting Primary Residence Then Moving Back

4 Replies

Good Day,

My wife and I are just getting started in real estate investing. We purchased an investment property (single family) at the end of last year an put in lots of sweat equity, it is now bringing in about $400 a month in income. We purchased our primary residence 3 years ago and did a recast on the mortgage after selling our previous primary so we have about 140k in equity.  By doing so our payment is low enough and our rent value is high enough in the area we could bring in $800-$1000 a month in income by renting it out. It is move in ready.

We would like to purchase a property to live in and fix up while we rent our primary for 2 years then move back in as our primary (once our first child is school age).

The advantages I see are essentially this sets up up to purchase at least 2 more properties (one with the extra income and one we would be living in)

The dis-advantages I see are potential tax issues.

What disadvantages, if any, do you see?

Thank you for any input on this situation.

@Justin Juhan - I’m not a cpa. If you have lived in your personal home for 2+ years and it appreciated (140k?) you can sell it and keep that money tax free. If you rent it, you’ll depreciate it while it’s rented (approx 1/29 value per year) and when you sell it you’ll owe depreciation recapture (25%?) on that money (ie 25% x 2/29 x the lower of the fair market value the day you transfer it or your cost basis (ie bought price plus rehab costs when you were living there).)

@Natalie Schanne - the home has only appreciated about 40k, the other 100k in equity came from proceeds on the sale of our previous primary we purchased in 2010.

Our plan is to live in this house until all our children are out of school. We bought into the district for that reason, but we got in early and see that we could make ~20k to invest in other properties just by moving twice.

So if we rent for 2 years, depreciate those years and sell it in 20 years at that time we would pay taxes on ~25% of 2/29 the (original purchase price +any rehab)

At original purchase price of 280k that means we would owe about $5000 in 20 years? Not bad for 20k in investment money now and hopefully this house will  appreciate much more than that over 20 years.

Please let me Know if I'm missing something. Thanks!

@Justin Juhan congrats on the investment property! As far as the tax issues go here's what you're looking at. I'm not a CPA so you should consult with yours, but these are the basics for your situation.

Capital gains exemption on personal residence - This is the 2 years out of 5 rule, if you've lived in a home as your primary residence for 2 out of the last 5 years you get a capital gains exemption of $500k since you're married (it'd be $250k if you were single) Meaning the home can appreciate $500k or less and you'll pay no capital gains as long as you meet this 2 out of 5 requirement. Since you lived in it as a primary residence before making it a rental you'll get the full exemption when you sell as long as it's a rental for 3 years or less to still meet the 2 out of 5 requirement. With the new rental becoming your primary residence for 2 years while you fix it up and then move back to your current residence the new rental would qualify for the exemption if you sold it within the 5 year period. You can only use the exemption every 2 years so you wouldn't be able to sell both within 2 years and double dip the exemption.

Depreciation - Whenever a property is "in service" as a rental you must claim depreciation. In service means it's ready and available to be rented whether it's actually rented or not. Some people mistakenly think they shouldn't claim depreciation so they won't have to pay recapture upon sale. This is incorrect since the IRS figures depreciation recapture on what is allowed or allowable meaning if you don't take it they'll still tax you as if you did. Recapture is figured at the lesser of your marginal tax rate or 25%, so if you're in a higher tax bracket you end up repaying significantly less in recapture than the benefit you received. Residential rental property has a depreciable life of 27.5 years. The property is broken down into land value which is non-depreciable and improvement (building) value which has the 27.5 year schedule. So if you paid $100k for a property and it has 20% land value you depreciate the $80k improvement value over 27.5 years for ~$2,909 depreciation expense per year. The first year and last year will be adjusted depending on when the property is placed in service. This is pretty simple for your CPA to figure and the depreciation tables are available online in IRS publication 946: How to depreciate property. 

Depending on the cost of the property and your specific situation it may be advantageous to look into a cost segregation study which will allow you to take advantage of accelerated depreciation and due to the new tax law maybe even bonus depreciation depending on when contracts were signed to purchase the property (after 9/27/17 qualifies for 100% bonus depreciation on assets with life of 20 years or less - the 5 year tangible personal property and the 15 year land improvements in a rental) If you have any questions on how that works feel free to PM me.

Hope this helps.

Paul, thank you for taking the time to type that up, it's very helpful and explains really good options for our situation. I have always done my own taxes but last year took me a lot of time and I didn't even have a rental in service then so I am seeking a CPA this year. I will save this post to bring up in discussion. 
We put about 5k in our rental to get it ready to rent and I know I would not catch everything especially with the changing tax laws. I'll have to check the contract date, I know we closed in December but it was delayed so fingers crossed it was after 9/27/17.



Originally posted by @Paul Caputo :

@Justin Juhan congrats on the investment property! As far as the tax issues go here's what you're looking at. I'm not a CPA so you should consult with yours, but these are the basics for your situation.

Capital gains exemption on personal residence - This is the 2 years out of 5 rule, if you've lived in a home as your primary residence for 2 out of the last 5 years you get a capital gains exemption of $500k since you're married (it'd be $250k if you were single) Meaning the home can appreciate $500k or less and you'll pay no capital gains as long as you meet this 2 out of 5 requirement. Since you lived in it as a primary residence before making it a rental you'll get the full exemption when you sell as long as it's a rental for 3 years or less to still meet the 2 out of 5 requirement. With the new rental becoming your primary residence for 2 years while you fix it up and then move back to your current residence the new rental would qualify for the exemption if you sold it within the 5 year period. You can only use the exemption every 2 years so you wouldn't be able to sell both within 2 years and double dip the exemption.

Depreciation - Whenever a property is "in service" as a rental you must claim depreciation. In service means it's ready and available to be rented whether it's actually rented or not. Some people mistakenly think they shouldn't claim depreciation so they won't have to pay recapture upon sale. This is incorrect since the IRS figures depreciation recapture on what is allowed or allowable meaning if you don't take it they'll still tax you as if you did. Recapture is figured at the lesser of your marginal tax rate or 25%, so if you're in a higher tax bracket you end up repaying significantly less in recapture than the benefit you received. Residential rental property has a depreciable life of 27.5 years. The property is broken down into land value which is non-depreciable and improvement (building) value which has the 27.5 year schedule. So if you paid $100k for a property and it has 20% land value you depreciate the $80k improvement value over 27.5 years for ~$2,909 depreciation expense per year. The first year and last year will be adjusted depending on when the property is placed in service. This is pretty simple for your CPA to figure and the depreciation tables are available online in IRS publication 946: How to depreciate property. 

Depending on the cost of the property and your specific situation it may be advantageous to look into a cost segregation study which will allow you to take advantage of accelerated depreciation and due to the new tax law maybe even bonus depreciation depending on when contracts were signed to purchase the property (after 9/27/17 qualifies for 100% bonus depreciation on assets with life of 20 years or less - the 5 year tangible personal property and the 15 year land improvements in a rental) If you have any questions on how that works feel free to PM me.

Hope this helps.