Living in New Construction to Avoid Capital Gains

20 Replies

I spent a long time looking for an existing thread on this but could not find one. I have been a reader for a long time and this is the first time I have created a thread because every other time I have found one. Here is my situation:

I purchased a house a few years ago from a hoarder and got a great deal. It is a large lot in central Austin. I am am now finishing subdividing the lot to build new on what was the side yard. What I am wondering is what people think about living in new construction as my primary for 2 years to avoid gains/income tax. The main question I cannot find data on is whether the value of a home drops when it is not brand new. Obviously, when you drive a new car off the lot it loses most value. Homes are not that extreme, but how much so? How much more do people want a brand new home vs a 2 year old home? Also, how does the my capital gains exemption work if I keep the subdivided part of the lot?

Estimates: I purchased at $355k. I have around $50k in on renovations from when I purchased and will put another $100k before sale. I think the existing house will sell somewhere around $900k. Will hopefully not pay any taxes on that transaction because it is my primary. Then, we will build new on the vacant lot we subdivided off. I am uncertain what the return will be but I estimate $150/sf on construction and $350/sf (conservative) sales price over 3000sf. I could clear around $600k. 

It seems like a no brainer to try to shelter that from the potential of income tax by living in it. Does that sound right? Does anyone know if a 1031 would work in this situation even if I have not rented it out? 

Thanks in advance for your thoughts. 

Just to get it out of the way, the 1031 will not work for you. That only applies to real estate you purchase and own as an investment property where you collect rent, file a schedule e, etc...

A builder, as an example, builds property to sell. It is his inventory so to speak. The income and expenses associated with the business of building the homes is captured on a Schedule C. 

So you lived in the hoarder house for two years and thus when you sell it, you will be exempt from capital gains on your profit up to $250K ($500K if married). You can do this as often as you like for the most part except that you must live in a house for 2 of the previous 5 years so essentially you can do this every two years. In your case, you are essentially building your new house. You will have to have lived in the new house for the two year minimum before you can again claim the exemption. You could even rent it out for a year and then move back in for two years and then rent it for another year and still meet the requirements. That's beyond your concern I think but just giving an example. 

I would think your basis on the new construction would be the cost of the land plus the cost to construct the house but I'm not a 1031 specialist. After the two years you will sell the house and then calculate the gain. If as an example, you bought a house for $100K and then tore it down and built a new house for $200K your basis is $300K. 

This is how I understand the law anyways. Maybe others with more experience will chime in as well. 

Builders live in a house two years and sell with no gains taxes all the time.  Flippers, too.  I would guess the more central you are the less likely you would see depreciation for a 2 year occupancy over brand new--no new competition--if you take good care of the place (no lets or kids helps).  (I would think another risk would be to defer selling for two years and miss selling at the market top, if Fitch is correct in claiming Austin is 20% overpriced.)  The higher your price range the more picky your buyers will be on "dated" finishes, eg if somehow blonde wood becomes all the rage, higher end buyers will want it but mid-range buyers would likely be thrilled just to get any color hardwoods over laminate.  Styles don't change super fast...but you sure dont see Tuscan much nowdays.

You could rent the house instead of selling and then do a 1031 after a year or so, but you can't take any equity out in a 1031.

@Rob Beland Thanks for the reply! The piece I was wondering about with the 1031 was whether somehow having owned the land for the last few years would somehow qualify me if I consider the land an "investment". I have found the rules to be fuzzy around this kind of thing in what I have read. 

@Marian Smith Good thoughts, especially on the risk of missing the top of the market. I had not thought about it from that perspective. I think the odds of the market rising over 2 years are as good as falling here in Austin. I do have young kids which will probably put some wear and tear on the place but we would probably move out and touch up before going on the market. The biggest fear I have is that there is a buyer out there somewhere who is willing to pay an extra $100k to have it new. I would never do that but I do not understand the psychology of the new home/car buyer. That theoretical $100k would be enough to pay my capital gains tax bill and I would have that cash/credit to work with immediately instead of holding it in my primary for 2 years. 

Just noticed that I think I made a nube mistake here. I guess I was reading in Investor Deal Diaries and when I created this story it was posted in that category. Anybody know how to retag/recategorize? 

Yes @Will R. raw land (bought and held for investment) does qualify for a 1031 exchange. I was looking at it from the perspective as you being a builder but a rental property can be 1031'd into raw land and vice versa. Im not sure how it would work since you are subdividing your own land. I think you would have to subdivide it then hold the new lot for the minimum two years? You should contact a 1031 specialist about the details. 

very interesting thread... although 2 years seems like a long time and the rates will be higher by than.... I keep hearing the FED will only raise .2% but we all know the greedy banks pay .2% more and they will probably be charging 2.2% more so the homebuyers in Austin may not be willing to spend as much on the price of a new home when the monthly payments will be much higher.... I have recently noticed a bunch of new mansions being built in queens ny near my grandmothers place and i thought it was weird but it put 2+2 together and it made perfect sense Scarsdale and Manhasset are now so overpopulated and the property taxes are so high it makes sense for the upper class to just live in the city than the suburbs and save 40k$ a year in property taxes on there 6million dollar mansion and send there kids to private school bc after all there kids will graduate and move on hopefully and taxes are forever :(  With that in mind if your in the really hot trendy central area with great property taxes than yea you'll probably be golden in 2 years but if the area is really hot but not so central with higher taxes maybe not so golden

so all in all i think take all the advice here with a grain of salt bc it may be the smarter thing to live there if you know you want to live in that area anyways and can afford to do so but at the same time you don't want to commit yourself to something that may close the door to other opportunities further down the line...

good luck and be sure to let us know how everything turns out...

@Will R. Great strategy to stay in that first property and take advantage of the sec 121 primary exclusion.  I didn't catch whether it had been your primary since buying it.  If you are converting it from a rental there will be some proration and limitation of gain exclusion and some depreciation recapture but it still can be a great deal for you.

Timing is going to be part of the issue but it really all boils down to intent which is why it seems fuzzy to you.  Rental income is not a requirement for 1031 treatment.  Neither is a specific holding period.  What was your intent when you spun off the extra lot?  Did you do it just to sell a lot  or build and sell - then your intent was resale and you could not do a 1031.  Did you separate it because that was the highest best and most logical use for that property and your intent was to hold it (long term appreciation or uncertainty of final best use) - then a 1031 would be appropriate. 

@Dave Foster Ah... Intent is where it gets really fuzzy. I purchased this house because it was a great investment but I live in it as my primary residence. I will be selling the house as a primary residence. That leaves a lot that was previously attached to my primary residence which was purchased as a part of a "primary residence investment". That side yard was mostly unused because I never cleaned it up enough to use as a yard. 

well how long have you lived in the first house and how fast will you be building the second

ALSO i know many municipalities have limits to the size of a secondary structure BUT maybe you can build the new house as a guest house while your living in the main residence and than maybe even sell the both for a good profit to your buddy for what you could get for the two separately..... have him split it and than sell for no profit so he doesn't have to pay the taxes and yea i know he may have holding costs but just pay them for him and give him a few grand for his troubles it would save you two years of your life not to mention a small fortune in taxes :)

@Peter John K I have been in this house for the last 3 years. You have to subdivide in Austin to go bigger than 850sf on a back house. Plus it is easier to sell a standalone in this high end neighborhood. 

@Peter John K  Interest rates... That is another piece I had not considered.

Pros for Occupying:
- No tax (not sure if I would otherwise pay capital gains 15% or income tax 40% in this situation)
- If it were income tax I am assuming it would be disastrous for my w2 taxes as well
- 2 years of appreciation (currently 5-10% in Austin but what does the 8 ball say?)
- Living in a fancy new house and having it paid for by the tax savings

Pros for Selling:
- Selling a NEW house (what is the % or $ value of this?)
- Immediate access to cash/credit for next opportunity
- Low interest rates for buyers
- Market is hot (but will probably remain hot for SFR in central austin)
- No carrying costs/interest payments on a house that is nicer than our needs
- Do not have to fix wear and tear

Anybody out there who has made this kind of decision before that can weigh in? 

I never made any decision like that but how far along the new build are you?

perhaps you could live there while it is being built even if you happen to sleep eat and poop next door.... that could save time

I think the most important factor is where do you want to live because if you want to live in that area than it may be worth it unless you can rent a smaller more affordable place for less money and the main factor is you financing because if you somehow got a builders loan and have to refi or sell to make the ballon payment in a few years that where you may have the problems regarding interest rates... but least you have your current house already paid off than just re fi traditionally with a fixed rate and you'll be fine so when you sell that one for a profit your new free house really will be free and paid off even if the rates go up....

its getting to that point in our economy where people need to look closely at adjustable rates or short term ballon payment loans that will require a refinancing in a year or two when the rates will likely be higher....

@Peter John K We are finalizing the subdivision now. No digging yet. The profits from the sale of the house (hopefully this summer) should cover the cost of the construction. So, no loan involved. 

mhmm so than if the house sells before you have the new house framed up and (not sure about inspection timings and requirements in your area) it takes a year to complete it than where will you be sleeping... i guess if you had your DL adressed there and you stayed at your parents or a friends place you would be technically living there because they don't know if you have a mobile home parked there or not unless the area specifically prohibits it.... its very possible you could save the money on the taxes without ever moving into the new home but I'm no lawyer or tax specialist so you shouldn't take my word for it and it may not exactly be the most legal or ethical way to do so...

Originally posted by @Will R. :

@Dave Foster Ah... Intent is where it gets really fuzzy. I purchased this house because it was a great investment but I live in it as my primary residence. I will be selling the house as a primary residence. That leaves a lot that was previously attached to my primary residence which was purchased as a part of a "primary residence investment". That side yard was mostly unused because I never cleaned it up enough to use as a yard. 

The term investment is defined differently for 1031 Exchange purposes.  Property acquired and held for rehab/sale (flipping) is not held for investment but rather is held for sale (e.g., inventory in your real estate business).  Property acquired and held for rental or investment purposes is held for investment and does qualify for 1031 Exchange treatmentt.  Property that is acquired as/for your primary residence is held as your primary residence (it may or may not increase in value, and your intent may have been to buy it with investment in mind, but your intent was really to use as your primary residence).  The length of time is only part of what an auditor would look at when they are trying to determine your intent.  It is all about intent.

The property will only qualify for the 121 Exclusion if you have owned and lived in the property as your primary residence for at least a total of 24 months out of the last 60 months.  Living elsewhere during construction will not satisfy the requirements.  Making it appear that you live there may be considered tax fraud. 

I think a Buyer paying a 10% premium for a brand-new spec house versus 2 year old house is doubtful.  Now if you get them during construction and allow them to customize all items your margin would likely go up.  But that has more to do with luck.  

Why not build and refinance.  You get the cash out to use now.  

Hi @Bill Exeter . Thanks for the reply! I would definitely actually live in it 2 years before attempting 121. What I hear you saying is that the 1031 "intent" is judged at purchase and because these two properties were bundled at purchase and I purchased as a house to live in, neither can be considered an investment. Does that sound right? 

@Steve L. This is what my gut was telling me but I have had a hard time finding examples. You seem to have a huge amount of experience with SFH which makes me think you are right. The customization aspect is interesting. I am not sure I want to deal with a buyer that much though.

On the refi, I would still be taking a major hit on my DTI but I guess that does not really matter because I would have cash to work with.

Hi . Thanks for the reply! I would definitely actually live in it 2 years before attempting 121. What I hear you saying is that the 1031 "intent" is judged at purchase and because these two properties were bundled at purchase and I purchased as a house to live in, neither can be considered an investment. Does that sound right? 

Your intent is judged at original purchase, but it is also judged as you go because your intent can change.  You would have to be able to demonstrate your intent should you get audited.

have you thought about starting a corporation based in nevada... i believe they have no corporate income tax in nevada than you might be able to re invest some of the profits into more real estate deals and give yourself a salary although I'm no tax professional but you may be able to not live there and save on most of the taxes and than just pay income tax on what you need to use for yourself and reinvest the rest of the money and figure out how to write it off... Maybe find a good deal on a john deer backhoe write off what you spent on it and than rent it out or.... If your eyeing a new pickup truck you could probably get the 75000$ king ranch heavy duty f250 and write that off... If i had to chose between paying 100K in takes or 40K in taxes and buying a nice big truck and backhoe...

i hear people talk about llc this and s corp that to protect from liablitlities but what about tax benefits.... I did find a local document preparation service on CL once that charges 425$ plus 120$ a year for the custodial service and they set everything up for a Nevada corp and handle the yearly filings etc.... that CL add had me thinking a while although it may not be worth it in some cases but if you talking a six figure tax bill it may be worth looking into it...

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