Capital gains tax, sell or rent/ heloc?

Question

Greetings! I am trying to build up a rental investment business in KC to provide passive income to eventually replace my primary income. I need some strategic and tax advice.

Here is the Background:

I own a 4 bedroom/2 bathroom house with a large attached lot in KCMO. Currently the market comps supports could sell for $245,500. I bought it for $110,000 in March 2013. I have a primary residence loan at 4% originally for $105,000 and I have about $78,000 still on the loan to repay. My monthly mortgage, tax and insurance is $760 /month. I have made previous improvements while living there over the years totalling $21,000 in CapEx and repairs since 2013.

I have two options I see and I am trying to figure out which would give me the best start on building my property investment business.

Option 1:

I could rent the house in today's market for $1600-$1800 /month. For assumptions I am assuming I rent the house to a single family for $1700 a month. With mortgage/Insurance/Taxes, maintenance, management, CapEx, and vacancy expenses I still make a significant free cash flow per month. Here my IRR and Cash on Cash return is very strong.

If I would use a HELOC to pull out up to 80% of the equity and buy/renovate other smaller rental properties using BRRR to get cash flow and build equity over time. In my assumptions I figure 6% interest on the HELOC and 6% interest on the eventual refinance for 30 years after remodeling and renting the new places. I am shooting for $250 per single family home free cash flow after all expenses each month.

An advantage of this scenario is that I do not sell the home, keep leverage for tax advantage, and do not incur capital gains tax in a sale now. This strategy gives me a very nice first rental property and allows the property to continue build equity that will come because the neighborhood is still actively flipping.

Option 2:

I could sell the house for $245,000, and with a 6% realtor commission I could pocket approximately $230,000 cash. I could then put this cash in a money market and use debt free cash to buy deals, make repairs, etc. I can get an exemption from capital gains tax this year because I lived in the home as a primary residence for two out of the last five years.

The house is in an Opportunity Zone in KCMO so I have also thought about forming a LLC and an Opp Zone fund myself and then investing from that fund into new rentals.

Which of these options, or another option I have not thought of, is the most advantageous to started on growing my rental investment business?

Any advice you can offer would be of great help! Thank you.

Nicholas Aiola · Answer

@Dave Foster Correct, the 3 rental years after moving out (from your example) would not be considered a period of nonqualified use, as per Section 121(b)(5)(C)(ii)(I).

Dave Foster · Answer

@Justin Mathews, Well now!!!  That's interesting.  I love to buy double and triple lots with one house on them.  The house stays and get's juiced if the lots can be split with it on it.  and and two new houses go up beside it.  In gentrifying areas - Wash Park  or the Highlands in Denver, West Port in KC, the old North East  in St Pete, (name any other of 1000 old neighborhoods that are suddenly hipster friendly)  this can be a gold mine.

So, if you've got an extra lot you need to think about.  Chances are you may be able to get as much for just the house as you can if the lot is included.  But at least by separating it you have it on your side of the table for negotiating.

Here's what I'd be thinking about.

1. If it has a value now and you sell with the house it will be tax free as long as you're not at the maximums.

2. If the neighborhood will support new construction that could be a very good easy passive hold.  But you'll have taxes and a little carry.  Sometimes a neighborhood is going the wrong direction and you can't give that lot away in the future.

3.  Maybe ask a builder in the area what they would give for that lot by itself.

Justin Mathews · Answer

@Dave Foster this is what I was thinking. I might hold the lot. I've got two years at least to rent before my 125 exclusion runs out. Plan now is rent for two years, sell ( possibly to my LLC), take the exemption and separate the lot for single family development.

Natalie Kolodij · Answer

Ya your accountant is wrong

If you move INTO a rental- you deal with prorated gain.

If it's your primary first, then you have 3 years to sell it after and still qualify for 121 exclusion

Scott McIntosh · Answer

Agree -- that kind of tax-free profit on an owner-occupied property is hard to beat.  I'd sell and look for ways to use those proceeds for future investments.

Justin Mathews · Answer

@John Barnes I really like this idea. I'd thought about it but read that investing  from an LLC precludes my first few deals from.taking advantage of lower rate lending for my first four or five deals as a private consumer using conventional personal financing. Thoughts? @dave

John Barnes · Answer

I've not done it yet but there is a strategy that is worth mentioning.  Establish a corporation and sell your property to it. You still control it as a rental but you get your exclusion, plus the value for depreciation starts at market value rather than your current cost basis. Since the corp has a separate EIN and is a separate entity from you, it's legal.  Worth looking up and reading about it if I were in your situation.

Sincerely,

John

Justin Mathews · Answer

@Dave Foster any thoughts on my comments above on keeping the garage and empty lot after selling the house?

Justin Mathews · Answer

You all are AMAZING. So I definitely hear sell it. The decision then is 1. whether to keep the yard/ empty city lot for future development next door and 2. whether to hold the house for up to three years to still get the 125 exemption while renting it so that the appreciation continues to rise. This assumes I could deploy other limited resources to buy deals over the next three years while waiting to sell. Might be too much trouble. There is a huge development that is down the block that is creating big value for the home value and comes online in the next 2 years. Of course, the market crash between now and then too...

Dave Foster · Answer

@Justin Mathews, As soon as you do that you start jacking your IRR and ROI/opportunity cost calcs.

Ask yourself why you love this property?

If you want to thread the needle and postpone a decision then go ahead and rent it for up to 3 mores years.  Your accountant is wrong.  Since the property started as your primary residence the three years immediately following your move out do not count toward non-qualified use (unless there's something new on the horizon I don't know - @Natalie Kolodij?, @Nicholas Aiola ??).

So you rent it for a bit more and then sell and still get the full primary residence exemption and only have to recapture the depreciation.

But... You also have a rentor with tenant damage and the need to spruce up for a sale later.

Unless I'm missing something this thing screams sell - get the money off the table and repeat with tax free dollars.

Capital gains tax, sell or rent/ heloc?

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