How can I reduce capital gains tax on a new rental home?

Question

I bought my primary residence 4 years ago for $150k.  Now it's worth $200k because of market increases in the area.  I'm planning to buy a new house to live in and rent out the old one, but I'm concerned about becoming liable for the $50,000 capital gains tax on the price increase.

I know that I won't have to pay capital gains tax if I sell it now, but I think I will if I rent it out and then sell it in 4+ years.  Is that right?

If so, is there anything I can do about it?  Is there a way to raise the basis to 200k now so that I won't have to pay as much capital gains tax in the future?

Wayne Brooks · Answer

@David Dachtera There's no repurchase at a greater value requirement for a primary residence 121 exclusion.  You're showing our age, that was eliminated 10-15 years ago I believe.

Dave Foster · Answer

@Charles Jessup, as long as you have lived in that property for two out of the previous five years you can take the primary residence exclusion and the the first $250K of profit ($500K if married) of profit (does not matter when appreciation occurred) is tax free.  So you have a three year window after you move out to decide whether to access that or not.

If you want to keep it beyond that window as an investment then you lose the opportunity for primary residence exclusion but you can always do a 1031 exchange and defer the tax into the next property.  As long as you own that property or as long as you do another 1031 you can defer the tax indefinitely.

David Dachtera · Answer

Just to clarify, you would owe tax on the $15K, not be taxed in the amount of $15K.

As long as your new home costs equal to or greater than the selling price you get for your home, there is no tax on the gain.

Please verify with your tax professional (I'm not one).

David J Dachtera

"Success is not a destination. Failure is not an event. Success is a process, failure is a choice."- DJ Benedict

Charles Jessup · Answer

I just saw that Brandon Hall wrote a blogpost on  biggerpockets about this very topic.   He goes into detail on section 121 rule, and explains exactly how it works.  Check it out if you're interested.  https://www.biggerpockets.com/renewsblog/2016/05/0...

Thanks biggerpockets community for your helpful advice!

Bill Exeter · Answer

Hi David,

The comment above "equal to or greater than the selling price" was under the old 1034 Exchange (Section 1034 of the Internal Revenue Code).  This was repealed effective December 31, 1996 and replaced with the 121 Exclusion.  The 1034 Exchange was tax deferred, but the 121 Exclusion is tax free.  Tax free is always better than tax deferred.  The only time this is a problem is when the gain exceeds the $250,000/$500,000 exclusion limits.

Bill Exeter · Answer

Hi Charles,

The qualifications for the 121 Exclusion (Section 121 of the Internal Revenue Code) have been discussed above.  The easiest way to determine if you qualify for the 121 Exclusion is to use the "60 month look back test".  You look back 60 months from the date that you close on the sale of the property and as long as you can still say that you have owned and lived in the property as a primary residence for at least a total of 24 months out of the last 60 months you will qualify for the 121 Exclusion.  This effectively means that you have a three (3) year window from the date that you move out in which to sell and close on the sale before you no longer qualify for the 121 Exclusion.

Once you exceed the three (3) year window the property will no longer qualify for the 121 Exclusion, but it will be considered 100% rental/investment property at that time and will qualify for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code.  You could sell the property and defer the tax by structuring a 1031 Exchange.

The vast majority of advisors generally recommend that you hold as rental/investment property for 24 months and then you have an additional 12 months in which to market and sell your property and still qualify for the 121 Exclusion.

Charles Jessup · Answer

Thanks for the answers everyone.

Right now I'm planning to rent it out (my first rental!) and deal with the capital gains tax if and when I eventually sell.

David Dachtera · Answer

@Wayne Brooks,

That's why I have an accountant!

David J Dachtera

"Success is not a destination. Failure is not an event. Success is a process, failure is a choice."- DJ Benedict

Charles Jessup · Answer

So does it matter if the appreciation occurred while I was owning or renting the property?

Wayne Brooks · Answer

Close, you'd have 3 years to sell it after you move out, to avoid cap gains.

How can I reduce capital gains tax on a new rental home?

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