Is my Accountant correct, rental property question?

12 Replies

Hello All, 

I am looking for some advice or maybe assurance that the accountant I have been using for the last few years is actually correct with the questions I have been asking him. 

I reached out to my accountant regarding the rental property I have in Colorado. Near the end of 2017, a forest fire burned down my property along with about 300 other homes in the area. The property is just now finally being rebuilt after a terrible arrangement of issues that occurred between my insurance and the county... Either way, the property is finally being built and slated to be completed in a few months, roughly end of October-November. 

I reached out to my Accountant with the question of how would taxes occur on the property if I was to place it up for sale with the intentions of selling it after the 2-year mark of the fire occurring. If I understand taxes enough I would think I would fall under the grey area of "living in it 2 out of the last 5 years" of the laws, because technically it was not rented out this entire time nor advertised as a rental. My reasoning for selling the property is the following, I purchased the property in 2009 for 68k with 0% down VA loan @5.5%, put about 20k into renovation before the fire. Comps on the property in the area are about 170-200k, with 200k being the freshly renovated properties. Since the property would be brand new, I would think I could at least get 200k on the sale of the property. Currently, I owe about 33k on the loan and if I sold it for 200k, would net me 160k~ish and use that money to purchase another property here in Florida where I live now. This would free me up from having to file taxes in Colorado anymore and free me up to use my VA loan entitlement again on a new property, which I have been looking to purchase a new primary residence home. Just doing the basic math, it would take roughly 29-30years to recover a return of 160k based on the cash flow I received on the property prior to it burning down...

The accountant is telling me that it's still technically a rental property, that I would have to pay back the depreciation I claimed on taxes along with cap gain taxes on the property if I sold it. 

Before the property burned down I was pocketing about $535/month in cash flow and having to file taxes in Colorado for the solo property. I was thinking of using the 160k and either buy like a 160k rehab property that can't get a loan or purchase a property in the 300k range and put 30-50% down. 

@William Huston

I am having a hard time understanding where your primary residence is. The house that burned down was a rental, yes? If your accountant filed your tax returns with that house as a rental- which it sounds like he did by giving you the write off benefits of depreciation on it - I don’t see how you could turn around and sell it as a primary residence. The IRS basically already has knowledge due to prior years tax returns that it is a rental.

Maybe go back and amend your tax returns? All in all I would just pay the depreciation recapture and the long term cap gains rather then risk an audit by the IRS.

I think a "Section 1033 Involuntary Conversion" would be the appropriate. See: Section 1033 

It works somewhat like a 1031 exchange except you have 2 years to designate the replacement property rather than the six months allowed in a 1031 and you don't need a QI to hold funds etc. It haven't seen it discussed much here on this site. If you want to buy a replacement property with the proceeds, looks like this is a perfect vehicle for doing it, i.e. defer the gain, avoid recapture in cases of a disaster such as yours.

Also with the 1033, unlike a 1031, you don't have to go thru the issues of primary residence, or a rental. The issue is your property burned down. Now 1033's are used in other cases of involuntary conversions, such as eminent domain, but fire disasters, YES.

Updated about 1 month ago

Also note that in special cases, the time frame is extended to 4 years.

Originally posted by @Frank Maratta :

@William Huston

I am having a hard time understanding where your primary residence is. The house that burned down was a rental, yes? If your accountant filed your tax returns with that house as a rental- which it sounds like he did by giving you the write off benefits of depreciation on it - I don’t see how you could turn around and sell it as a primary residence. The IRS basically already has knowledge due to prior years tax returns that it is a rental.

Maybe go back and amend your tax returns? All in all I would just pay the depreciation recapture and the long term cap gains rather then risk an audit by the IRS.

The property was purchased in 2009, i used it as my primary for 2 years, then in 2011 i received orders to New Mexico and turned it into a rental property. It was a rental from 2011 tell 2017. Taxes for 2018 the property was reported not available for rent on taxes for 0 days and when I do my taxes again for 2019, it will be the same.. 0 days.

 

@William Huston

"If I understand taxes enough I would think I would fall under the grey area of "living in it 2 out of the last 5 years" of the laws, because technically it was not rented out this entire time nor advertised as a rental."

Your accountant appears to be correct.  It's not a grey area...just because you didn't rent it for 2 years doesn't make it your principal residence.  Your accountant should explain the Sec 121 exclusion in detail so there's no confusion.

Originally posted by @William Huston :
Originally posted by @Frank Maratta:

@William Huston

I am having a hard time understanding where your primary residence is. The house that burned down was a rental, yes? If your accountant filed your tax returns with that house as a rental- which it sounds like he did by giving you the write off benefits of depreciation on it - I don’t see how you could turn around and sell it as a primary residence. The IRS basically already has knowledge due to prior years tax returns that it is a rental.

Maybe go back and amend your tax returns? All in all I would just pay the depreciation recapture and the long term cap gains rather then risk an audit by the IRS.

The property was purchased in 2009, i used it as my primary for 2 years, then in 2011 i received orders to New Mexico and turned it into a rental property. It was a rental from 2011 tell 2017. Taxes for 2018 the property was reported not available for rent on taxes for 0 days and when I do my taxes again for 2019, it will be the same.. 0 days.

 

 If you occupied it from 2009-2011 then it was not occupied as a primary residence for 2 of the last 5 years. 

I think your accountant is correct. 

Agreed, being vacant (or burned down) does Not make it your primary....you have to actually live in it for it to be your primary.  Even if you Did live in it for the last 2 years, you wouldn’t get the full 121 exclusion....you lost that after you moved out for more than 3 years in 2011....if you had lived in it the last 2 years, you would have resided in it for 4 out of 10 10 years...40% would have been excluded.

@William Huston , there's no gray area - either it was your primary or it wasn't.  That's going beyond gray - don't do that!.  

But I'm not sure you have to.  Theres one little thing you said that may have gotten missed - you lived in it for 2 years and then moved out and rented it for the next 7 years "because you were stationed in New Mexico."   @Natalie Kolodij and @Eamonn McElroy , would he be eligible for the active service exception giving him 10 years to sell and still get the primary exemption?

@Dave Foster

Technically yes Dave IRC Sec 121 does have preferential treatment for active service members, but I'm wondering if the house was completely rebuilt and the gates case law is applicable and Sec 121 is off the table here:

David A. Gates and Christine A. Gates v. Commissioner (U.S. Tax Court, Dkt. No. 19350-05, 135 TC 1, July 1, 2010)

Either way the OP should work with his CPA to determine options and the most advantageous tax treatment.

Thanks, everyone for your input, I was just trying to get more than one opinion. I asked over on the good old Reddit and it was the complete opposite, saying it should count for the 2 years. It sounds like I should just pursue the route of 1031 exchange for the first time and move it into a rental here in Florida. 

William - Two things. 

First, Thank you for your service. Second, I remember that fire in 2017. It was terrible and a lot of people lost their homes from that one.

Something you brought up that I haven't seen anyone else talk about yet, is your bonus entitlement with VA. If your purchase price for the home you bought in 2009 was $68K and you haven't used your VA entitlement since (not for a purchase or refinance), I would think you would have plenty of bonus entitlement left over to purchase another home with your VA loan without having to sell the current home in Colorado. Especially with the loan limit increases over the years.

You have two types of entitlement with your VA Home loan benefit. Basic entitlement ($36K) and bonus entitlement (25% of the county loan limit).

It's important to know that VA does not have a maximum loan amount, but right now VA will only guarantee up to 25% of the county loan limit as set forth by Fannie/Freddie or the FHFA if in a high-cost area. Since you've previously used your entitlement, VA will guarantee 25% of the Fannie/Freddie loan limit minus any previously charged entitlement. Since your purchase price was $68K when you bought, this means that your entitlement charged would only be $17K ($68K x 25%).

If you wanted to do a 0% down payment using the VA loan again (without selling your Colorado property), you can do that. We just need to calculate how much bonus entitlement you have remaining after the $17K charged entitlement. Also - yes, you can have two VA loans at the same time. Especially with your circumstances. 

Currently, the national Fannie Mae/Freddie Mac loan limit is $484,350. In certain high cost areas, the maximum loan amount may actually be higher, as determined by the FHFA. For example, in Denver County here in Colorado, the high cost loan limit is $561,200. This is important because your bonus entitlement is dependent on the county loan limit. In fact, if the county loan limits increase, you would actually have more bonus VA entitlement, even if you had previously used it all up. I'm getting on a tangent, so let me get back on track.

[OKHang In There With Me - Here Comes The Math] 

Assuming a county loan limit of $484,350, your VA entitlement will guarantee 25% of the loan amount up to the loan limit. In other words, $484,350 x 25% = $121,087.50. The $121,087.50 is your bonus entitlement if you had full entitlement. Now, since you've previously charged $17K on your VA entitlement for the $68K home purchase from 2009, we need to subtract $17K from the $121,087.50, meaning that you would have $104,087.50 in remaining bonus entitlement leftover. Since the $104,087.50 would guarantee 25% of the loan amount, this means you could purchase a $416,350 home without a down payment, and without needing to sell your home in Colorado ($104,087.5 x 4 = $416,350).

But what if your new home is $500,000?

Well, since your remaining bonus VA entitlement will only guarantee up to 25% of the loan amount, you as the veteran would be responsible for guaranteeing 25% of the loan amount beyond $416,350 with a down payment.

$500,000 minus $416,360 = $83,650

$83,650 x 25% = $20,912.50 down payment

You could still buy the $500,000 house, but you would need a $20,912.50 down payment. Effectively 4.18% down in this example. 

Why not buy a new primary residence in Florida with the VA loan using your bonus entitlement, wait for the home in Colorado to be re-built, and then either cash-out refi the home in Colorado or place a HELOC on your Colorado home?

Do you have to sell it? You would essentially have a brand new rental property. Almost like a BRRRR.

I hope this helps give you another perspective on your situation. 

Create Lasting Wealth Through Real Estate

Join the millions of people achieving financial freedom through the power of real estate investing

Start here