Best way to avoid paying Capital Gains Tax on primary residence?

Tax, SDIRAs & Cost Segregation
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Best way to avoid paying Capital Gains Tax on primary residence?

Kris Kahrs
Los Angeles, CA · Member since 2015 · 25 posts · 3 votes

Hi All--my husband & I are in the process of selling our primary residence in Los Angeles.  We have a lot of equity, we've been in it for 20 years in a trendy neighborhood.  We bought the home for $230K.  We may have $100K in repairs & improvements to add to the basis.  The realtor thinks we'll sell for a little over $1.1MM.  If so, then not only would we pay capital gains on the after exclusion margin of perhaps $200K, but the additional income might very well push us into a higher tax bracket. We're trying to buy a place for $800K to take our property tax basis to a new property.  We would like to borrow against the new property, deposit the cash into a fund with an adequate interest rate so that we can offset the interest we're making on the investment against the interest rate on a line of credit.  

What is the most constructive, most tax-avoidant strategy here?  Any help is appreciated.  Thanks!

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Brandon Hall
CPA · Raleigh, NC · Member since 2013 · 1k+ posts · 2k+ votes
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@Kris Kahrs be very, very careful with seller financing. It may look great on paper until the day the year the new owner decides to sell. In that year, you'll be forced to take a tax hit and will have few options available to you.

My suggestion: consider taking a HELOC/cash out-refi to buy your next place. Rent out your old primary residence for 1-2 years and then sell it to enjoy your Sec 121 exclusion ($500k gains excluded) and have the ability to 1031 the remainder gains over into a new investment property.

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  • Eric Dowling
    Real Estate Agent · Los Angeles, CA · Member since 2015 · 201 posts · 82 votes
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    @Kris Kahrs there are a few options for you in this situation. First it looks like you are taking advantage of prop 60 so you can keep those low property taxes which is great! Next to defer the capital gains tax on almost 400k you can do a number of things. What I have been using with clients with substantial equity is the deferred sales trust. 

    I would be happy to send you a link to some info, but to make it as simple as possible: your proceeds from the sale go into a trust, rather than you directly and it defers the taxes until you pull the money out. If you set it up right and invest the money from the trust you end up never paying or paying substantially less of  the capital gains.

    1Reply
  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
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    $330,000 basis.   $1.1M sales price.  $770,000 gain less some sales, closing costs AND married $500,000 so $270,000ish non excludable gains and you want to take your tax base under Prop 60 or 90 to your next $800,000 property.

    Are those your numbers?  Let's think about that.

    Eric, where are you getting the $400,000?

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
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    @Eric Dowling can we just only put the amount above the exclusion (~$270K) into the Deferred Sales Trust?  Also, does that make sense for that instrument?  We were planning on using the proceeds for the next house.  Buy the next residence and then strip the equity for use in real estate investment.  We wanted to have the liquidity.

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
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    @Thomas Harper Thanks for the offer.  I will keep this at hand.

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
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    Originally posted by @Account Closed:

    $330,000 basis.   $1.1M sales price.  $770,000 gain less some sales, closing costs AND married $500,000 so $270,000ish non excludable gains and you want to take your tax base under Prop 60 or 90 to your next $800,000 property.

    Are those your numbers?  Let's think about that.

    Eric, where are you getting the $400,000?

     Hi Bob--Yes, those are the numbers.  Our approach was to take back a 2nd for the non-excludable portion only.  What would be the pros & cons of such an approach?  Many thanks!

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  • Naseer Khan
    Attorney · Bay Area, CA · Member since 2016 · 164 posts · 135 votes
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    @Kris Kahrs It will be very difficult to wipe away a tax consequence entirely from the sale of your home. Unless your combined income is more than $465,000, your capital gains tax rate is only 15%, which would put your tax bill at approximately $40,500 (assuming $270,000 non excludable gain). This capital gain amount is not included in your taxable income, so it should not put you in a higher tax bracket (may need to confirm with a CPA). I think you are in a very favorable situation as it is. I know this doesn't provide you with an answer to your question but it's just some perspective. 

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  • Alex J.
    Investor · Tarzana CA and Houston, TX · Member since 2015 · 326 posts · 130 votes
    10y

    Refi cash out your place and then rent it out.  use proceeds to buy a place.  taxes defered you guys get a new place and you have somebodyg o pay the notes. Then when you pass yo heir they get market rate cost basis.  I think that might be a good solution

    1Reply
  • Alex J.
    Investor · Tarzana CA and Houston, TX · Member since 2015 · 326 posts · 130 votes
    10y

    that auto corrected horribly

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  • Account Closed
    Castlewood, VA · Member since 2012 · 177 posts · 57 votes
    10y

    Unless you have an anti-landlord agenda, doing a 30yr owner occupied cash out refi right now while you're living in the property would be ideal. 

    Use the cash as 20% down payment on a future residence and finance it using a new mortgage. 

    Best of both worlds: tax avoidance and additional income in a low fixed rate environment.

    Of course, this assumes: 

    • you won't have DTI issues using combination of 30yr cash out refi plus your new mortgage
    • you wanted a mortgage free retirement. 

    With rates this low, it's a worthwhile strategy to consider. 

    1Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
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    @Account Closed  there was a day when cash out refi above basis was taxable.. ? not sure now.

    Kris its only 40k in tax as someone else mentioned on  such a windfall fain just pay it now you tax planning is over and your have all this cash you can make those funds up on the next deal..

    sometimes I think we over think how to avoid tax... but that's just me I like paying a lot of tax that means I am making a lot of money  LOL... I know pretty rare perspective I understand that.

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  • Manolo D.
    Contractor · Los Angeles, CA · Member since 2015 · 4k+ posts · 1k+ votes
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    Deferred taxes is not a language I want to learn. I am with @Jay Hinrichs to pay taxes now and be done with it. I like being debt free. Borrowing against LOC is a little expensive and to place your money somewhere that would offset if not gain a little would be risky money.

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  • Loren O.
    Investor · Placentia, CA · Member since 2016 · 3 posts · 2 votes
    10y

    Kris has potential tax liability exposure at both the federal and state level.  From a state perspective, her taxable gain is included as part of her ordinary income...which may be as high as 13.3% (depending on her state tax rate).  

    As previously mentioned, consider re-financing to pull out some of the equity to meet your immediate needs and rent out the current property.  After some period of time (say 18 months), you can sale the property and benefit from the 121 exclusion and also defer the gain from the portion not covered in the exclusion via a 1031 exhange. There's a lot of assumptions here, but the moral of the story is that the potential tax liability probably warrants the advice of a trusted tax professional. 

    Congratulations and (respectfully) I'm more of the opinion that deferred tax is preferred in the hopes that you recognize those gains during a period of low ordinary income (i.e. retirement).  

    1Reply
  • Daniel Chang
    Professional · Riverside, CA · Member since 2009 · 254 posts · 273 votes
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    All tax methods are simply tax deferral.  I suppose if you keep deferring the tax until both you and your husband are dead, you can pass on the the property to your beneficiaries via a step-up basis.  Otherwise, you are eventually going to have to pay those taxes.  If you turn it into a rental with a goal of 1031 deferral, you are going to lose the 500K exclusion after 3 years.  

    You are already making a huge gain on the house with a $500K exclusion.  Just pay Uncle Sam his portion and move on.

    1Reply
  • Loren O.
    Investor · Placentia, CA · Member since 2016 · 3 posts · 2 votes
    10y

    There's strategies to benefit from the 121 exclusion on an investment property turned into a primary residence. So in theory, you wouldnt have to defer indefinitely, but you would potentially have some tax liability to account for the difference in holding period as a rental vs primary.  

    Congratulations again!

    1Reply
  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @Naseer Khan Thanks for your response.  I did research this online and am pursuing confirmation with a CPA.  When I find out for sure.  I'll post here, but I think it does push a to a higher bracket and triggers another special clause as well.

    0Reply
  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    Hi Alex-- yes this is one of the scenarios we're considering.  Still collecting the model data then we'll run the numbers to see which is the most advantageous.  Thanks for your response.

    @Alex J.undefined

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @Matt Castle - This is a definite possibility.  But, I went to a Meetup here on Saturday & discovered yet another scenario.  We have a street to street lot, almost 6K sq ft which is rare in this part of L.A.  The lot was 2 separate lots in the 20's, so there's a possibility we can divide our lot into 2 lots which if sold separately may yield a higher return.  One realtor I've spoken to about this says it is not advantageous, that it will merely decrease the price of the upper lot with the house.  But I've spoken to a potential equity investor who suggested we sell the property to a partnership, split the lots and sell both to a local developer.  Running this scenario past the escrow company today and an R.E. attorney.   Thanks!

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @ Manolo D. - I used to feel that way, but don't anymore.  Now I feel it's just like starting a business.  It's all risky.  I also now feel, that it's imperative to put your $$ to work and equity is your money.  It has no rate of return as it sits there and it's at risk.

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @Loren O. & @ Daniel Chang - Yes, there is a state income tax & local tax component as well.  And the house may sell for as high as $1.2MM which would then be ~$91K in capital gains tax, so as the am't creeps higher towards $100K, it starts to look like real money. I disagree that tax can only be deferred for as in the scenario where we take back a 2nd note for any am't above $800K for the house, the payments can be made over time, which then can be paid in years when there is no W-2 income or offset against numerous mortgage interest deductions.  I do think advance planning can be useful

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  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @Jay Hinrichs Yes, I get what you say.  Paying the $ can be simpler, but I like to check out all the options 1st, just because it's interesting what you can do when you ask other people.  Thanks for your response.

    0Reply
  • Brandon Hall
    CPA · Raleigh, NC · Member since 2013 · 1k+ posts · 2k+ votes
    10y

    @Kris Kahrs be very, very careful with seller financing. It may look great on paper until the day the year the new owner decides to sell. In that year, you'll be forced to take a tax hit and will have few options available to you.

    My suggestion: consider taking a HELOC/cash out-refi to buy your next place. Rent out your old primary residence for 1-2 years and then sell it to enjoy your Sec 121 exclusion ($500k gains excluded) and have the ability to 1031 the remainder gains over into a new investment property.

    4Reply
  • Kris Kahrs
    OP
    Los Angeles, CA · Member since 2015 · 25 posts · 3 votes
    10y

    @Brandon Hall  I like that idea.  It sounds very do-able.  Thanks for the response.

    0Reply
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