maximizing investment / Seattle-Kirkland / two rental properties

Hi BP community.

I am trying to figure out how to maximize my investment (and reduce tax liability) on two properties I currently own in Kirkland, WA. Here is some background:

In 2010 I purchased a 1.3 acre lot with a bank owned, tear down home on it. My wife and I remodeled it extensively over an 8 year period, then decided to lift the home, subdivide the lot into two, and build our ‘dream home’ on the new (larger) lot.

Turns out, we both feel the ‘dream home’ might be a little too dreamy for us and we want to move into something a bit more modest, and that is not as ‘costly’. We see this as a way to increase our assets long term as well.

I’m considering two main options (open to other ideas): 

1.  Sell both properties, generating $4.9m in equity, then purchase another primary residence and rental property that generates more annual cashflow.

2. Keep both as rentals, refi, purchase another primary residence.

I have yet to really think through the tax implications if I sell anything (that’s why I’m posting here!) but I imagine I’ll go with option 2.

Here is some of the high level numbers for reference.

Total Property/Land Value: $5,600,000

Total Mortgages: $725,000

Total Equity: $4,875,000 (87%)

Total Taxes: $25,054

Total Depreciation: $56,362

Total rental income: $174,600 (if we rent both homes)

Any guidance would be much appreciated!!