Capital gains tax

9 Replies

several years ago my parent build a cabin in Montana that they estimate is worth and would sell for 750,000 to 800,000. This is there primary residence, and are married so they would be able to keep the first 500,000 tax free. They own the property free and clear. Is there Any way around this? Could the do a cash out refinance for say 300,000 giving them something to pay off when they do sell so they would only clear 500,000 at the sale. If this is the case how long before they sell do they need to do the cash out refi?

here is am idea for them. since they own it out right, have them get a mortgage on it for as much as they can. the proceeds from refinancing are NOT TAXABLE. then, they sell it, and the difference between what they sell it for and what was owed is what is taxable. its done in real estate all the time

the $500k exclusion is on the profits.  Basically sales proceeds less the basis. Mortgages or loans are not part of the basis.  What did it cost to build the property?

I think regardless of financing, the tax on capital gains is due regardless.  If you can document the original land purchase and construction costs of 250k, this plus the 500k primary residence break would make it mostly tax free.  Even if you can only document a basis (your parents actual original cost) of $100k, best option might still be to pay tax and be happy with having the money free and clear after paying taxes.  A couple ideas (but you would need a trained adviser to tell you if you could really do this, I am kind of talking out my rear).  

Look into 1031 exchange, maybe there is a way to roll only the taxable portion into another investment (although I think it is all or nothing, and the 500k primary residence break would probably be better). 

Put property in a trust or some other kind of estate planning so it ends in estate.  When they are ready to move out, they could cash out a portion of proceeds through a mortgage, turn it into a VRBO or some other income producer.  When they do pass away, goes into their estate.  My understanding is that any capital gains don't count after death and the estate would not take this tax hit.  Although death taxes should be considered.

Maybe they could sell it under some kind of lease option. Somehow this might allow your parents to spread the sale over a few years (you must have lived in the house for two of the last five years).  Charge buyer a $50,000 option fee up front and $5k / month and must purchase outright in three years.  The payments would be income and taxable, but if timed right, you could have $50k income in year one (say you sell in December), $60k in year two (at $5k/mo), $60k in year three, then sell early in year 4 for $600k, which $500k would be tax free.  

Again, get expert advice, I have never done any of these, and don't really know all rules that apply.   

Also remember that the sales costs add to the basis. If they use a realtor that could be in the range of 70K.

Talk to a CPA.. Even on this board, there are some crazy dead wrong suggestions.  Doing a loan has absolutely no effect on cap gains...that's just scary someone suggesting it does.  1031's can't involve a primary residence.  If the cabin was only built "several years ago" and assuming they didn't build it for free, I'm guessing their basis is at least $250-300k which puts their gain under the $500k cap, as @Cal C.  pointed out.

@Wayne Brooks  

Could not agree more with everything you said.  The absolute first step I would take is not take any tax advice found on this board.  Talk to a CPA.  Just taking a quick scan of the comments here there is shockingly bad advice when it comes to tax questions.

Originally posted by @Mark Elliott:

here is am idea for them. since they own it out right, have them get a mortgage on it for as much as they can. the proceeds from refinancing are NOT TAXABLE. then, they sell it, and the difference between what they sell it for and what was owed is what is taxable. its done in real estate all the time

Mark, this is not true.  The taxable gain is what they sell it for, less selling expenses, less their cost basis (what they paid for the property).  The amount they owe (debt) has nothing to do with what their taxable gain is.  They will be able to exclude up to $500,000 in taxable gain as a married couple since it is their primary residence. 

Originally posted by @Patrick McGowen:

Look into 1031 exchange, maybe there is a way to roll only the taxable portion into another investment (although I think it is all or nothing, and the 500k primary residence break would probably be better). 

The property is being used as a primary residence, so the 1031 Exchange does not apply to them.  The 1031 Exchange is permissible only on the sale of rental, investment or business use property.

I would guess that their taxable gain is probably pretty close to $500,000, so the vast majority, if not all, of the taxable gain is likely going to be tax free under Section 121 of the Internal Revenue Code ($500,000 tax free exclusion). 

However, should their taxable gain significantly exceed $500,000, they could move out of the property and rent it out for approximately 24 months and then sell.  They would then qualify for the $500,000 tax free exclusion, and could defer the rest of the taxable gain through a 1031 Exchange since they have now rented the property out for 24 months (ish).  This is permitted under IRS Revenue Procedure 2005-14 for those who would like the citation. 

Originally posted by @Cal C.:

the $500k exclusion is on the profits.  Basically sales proceeds less the basis. Mortgages or loans are not part of the basis.  What did it cost to build the property?

I was hoping the OP would provide some idea of the cost of the house so we could work with that, but here are some straw numbers all assume a sell price of $800K.

If the cost to build the property was $300K or higher then the $500K for a married couple applies as long as it is their primary residence.  As I understand it they would owe zero Cap gains tax.

If the cost to build was under $300k, then any amount over $500k in profit would be taxed at long term cap gain rates (and possibly some obamacare tax).  For example if it cost $250K to build then you would owe long term cap gain taxes on $50k.  Sales price-basis-$500K exclusion.  (I'm excluding closing and selling costs here for simplification purposes.)

Yes you could do a 1031 exchange and it might make sense for some people, but for the vast majority it would be a heck of a hassle and not worth the effort.  

Bottomline- It is unlikely that they made enough money on the property to exceed the $500k exclusion. 

To reiterate one more time- Mortgages or loans have nothing to do with the Cap gains or exclusion on primary residences.  However, you can itemize mortgage interest but again that is totally separate from the cap gain/exclusion issue. 

To illustrate this last point- Say they built the property for $300K using their own cash and then took out a loan for $400K.  Their basis would still remain $300k.  In most cases, there are exceptions, they could itemize all mortgage interest paid on that $400k loan but in all cases it still doesn't affect the cap gain/exclusion.  At the closing table they would receive a check for the $800K less closing and sales costs and less the amount still due on the mortgage.  They would not owe any taxes and I don't believe they have to report anything to the IRS.  However, IRS publication 523 covers this in detail. BTW it also covers determining basis. 

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