Help--Tax shelter strategies for personal residence cap gains?

[Dakota Sullivan]

Hi BP fam;

CA resident here looking to shift equity from personal residence into primarily income producing stock. Due to runup in home prices in Bay Area over 10 years I've held my personal residence, I'm facing seven digits of cap gains. 

I'm familiar with the exclusions tied to principal residence that could shelter up to $500k between me and my wife (subject to earned income contingencies). I've also looked into Opportunity Zone funds, however they lock any funds invested up for 10 years and as of 2022 lack some of the previous benefits (up to 15% reduction in tax in 2026). However, two big questions that I need advice on:

1) Any shelter strategies for CA state cap gains tax? This is a killer and I can't find anything even acknowledging the state tax bite, much less how to minimize (if even possible)

2) If I want to roll a portion of the proceeds into a new personal residence, must I pay full cap gains on those proceeds then invest as fresh cash? There's nothing even approaching a 1031 strategy for rolling one personal residence into another without full tax burden on any cap gains?

Thanks in advance for any direction here.

Dakota

[Joe Homs]

@Dakota Sullivan you CAN actually do a 121 and 1031 exclusion on a primary residence.  Up to $500K for the 121 Exclusion and then the remainder you would need to do a 1031 Exchange to purchase rental property.  A good 1031 company can walk you through the process.

Good Investing...

[Dave Foster]

@Dakota Sullivan, I was going to echo what @Joe Homs said.  But there are a couple of extra steps. 

The 121 primary exemption is available on any property you have lived in for two out of the five years immediately prior to sale.  It does not have to be your primary when you sell.  You can wait up to 3 years to sell it and still qualify for the 2/5 rule. The first $500K of gain would be tax free.

The 1031 exchange is only available to properties you sell that are investment properties when you sell.  The use when you sell is key.  And of course the size doesnt matter you can defer all the tax on the sale.

So what some investors will do is to move out of their primary before selling and rent it for a year.  They may rent themselves or buy an RV, or move into one of their other residences.  But they turn their primary into an investment property.

Then after a year they sell the property.  Now they are selling an investment property so they can do a 1031 and defer all the tax.  But they can also take $500K tax free because they also qualify for the 121 exemption.  So they take the $500K tax free and buy another investment property as well.  And all of the tax is eliminated or deferred.  They can buy another primary with tax free dollars and repeat.  Or they can wait a year or so and then move into the new investment property and reverse convert it from investment to primary without a taxable event.

It takes a little runway.  But the rewards are spectacular when you can combine these two statutes.

[Dakota Sullivan]

Thanks both for your feedback. Dave, that approach sounds like it could solve our problems. We've had realtors approach us about clients wanting to rent luxury homes in our area, so we could probably generate positive cashflow on top of the tax sheltering. Of course the risk is that the froth has come off the market in a year and we're not able to achieve the sale price that we would today, but this give us another great option to consider.