Rental real estate taxation question

[PaloAlto]

Hi - not sure this is the right place to ask this but here goes:

We have an investment property (1 BR condo) in the same city as our primary residence (4 BR condo)

The investment property value has grown from $575K to $900K over the last 4 years since we purchased it. The property is currently rented out (rental income covers almost 95% of monthly costs like mortgage, taxes, HOA, insurance etc.)

My in-laws are looking to spend around 6 months in our town. Originally we got the place for them but since they are only around for 6 months I would rather find them a comparable rental for 6 months.

The exception to this would be if there is any way to use this as an opportunity to convert our rental back to a primary residence so we can sell it tax free in the near future. We are not planning to move from our current primary residence for a long time (possibly never) but would love to cash in on the appreciation by selling the investment property in a few years without paying taxes.

Am I looking for something impossible or is there a way to do this with the help of a tax expert?

Thanks in advance.

 

[pb4uski]

https://www.kitces.com/blog/limits-...-for-irc-section-121-capital-gains-exclusion/

Example 2a. Harold has a property in 2009 that was purchased for $200,000 and is now worth $350,000. It was rented for a period of years (during which $29,000 of depreciation deductions were taken), and last year Harold moved into the property as a primary residence. The current cost basis is now $171,000 (after depreciation deductions), which means the total potential capital gain is $179,000. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion.

 

[nwsteve]

Note in above example, the "29k depreciation recapture is not eligible for Section 121 Exclusion"--translation--you will pay ordinary income taxes on this all your depreciation recapture amount at your marginal rate in the year of sale. Depreciation Recapture applies at time of sale, NO MATTER how long you reside in any property previously rented. The only way to avoid paying tax on the recapture amount is a 1031 exchange (you swap your property for another "like investment" eg real estate.) You are actually just deferring the tax. The only other option is to leave to an heir.
Just working our way through this issue, since we start RMD next year and sold one of our rentals this year. Not only will the depreciation recapture push us up a bracket, we just hoping we can stay below the Medicare threshold to avoid getting dinged for a higher Medicare premium.

 

[pb4uski]

Why the ? You know the situation that you are in and the rules but chose to sell anyway.... first world problem.

 

[brucethebroker]

Don't let the depreciation recapture deter you from making the right move. Keep it in perspective. You will still save lots of money, even with recapture.

Consider: If you sell your current residence (CR), the tax free capital gains on that property can be invested and will make a dent in any recapture taxes due when selling your investment house (IH) in two years. If you move to IH, and sell two years later, you will owe recapture, but still receive tax breaks on the capital gains-more than if you never lived in it. Two thirds of a good thing is still better than just selling the IH without living in it and having recapture plus capital gains taxes. (Of course, you can kick that can down the road and do a 1031 exchange).

 

[brucethebroker]

Put it on paper-selling with recapture as a rental, and selling as a personal residence. Use a CPA if necessary. Above my pay grade, but I bet there is a good sized tax difference by moving in.

 

[pb4uski]

Given that you have no intent to make the 1 bedroom your primary residence for at least 2 years then you can't get the exclusion.

 

[Koolau]

Yeah, we went through this with a rental. Moved into it and then sold 2 years later to get the exemption - but had to recapture the depreciation. It's still a good deal. But if OP has no intention of moving into the rental for 2 years, the only option is to delay the inevitable taxation by keeping it a rental or doing a 1031 (which effectively keeps it a rental.) The in-laws do not change the equation as far as I know.

Best advice I can offer is to get a CPA or other "planner" and then structure the process of selling the rental (either with a 2 year move in or not) BUT plan all other taxable events to ameliorate the taxes as much as possible. This stuff isn't easy and there are plenty of "gotchas" along the way (MC costs, ACA maybe, etc. etc.) Get some professional help is again my best advice and you are paying nothing for the advice so YMMV.

 

[nwsteve]

Why the ? You know the situation that you are in and the rules but chose to sell anyway.... first world problem.

Fair observation but knowing the situation does not mean liking it ;-). The " " just represented my pique with the statutory rate of 25% on depreciation.
One of the reasons we pulled the trigger on the sale was this was our last year before RMDs and any sale would probably jump us two brackets instead of one.

 

[jkern]

I believe the tax rules changed with respect to getting your full section 121 exemption after two years. I think they made it a percentage of the time it was your primary residence vs. rental.

 

[CaliKid]

I would sell, 1031 exchange, buy 10 houses in Memphis (or other cash flow city) and have $10k+ gross rents a month. Easy.

 

[PaloAlto]

Thanks for all the replies! Looks like there is no easy way to avoid the taxes (while remaining alive so will just keep things going as is. Calikid - appreciate the suggestion. Was not intentional real estate investor but ended up with unexpected cash and decided to buy another home with it instead of mutual funds. It it easy to take care of being so close, so as long as I can keep it rented i will keep it. Maybe some day in the future might 1031 it and reinvest in a cash flow location.

Thanks all!