Selling rental to pay off primary house

[laurence]

I'm not looking to debate best use of money to death again, I promise.

I bought a ~1500 sq foot rental property 3.5 years ago and just figured we'd keep it forever, using the rental to supplement retirement income and then passing it on to heirs via our trust. In the mean time we've been paying extra on it to make sure it's mortgage free by retirement (about 15 years after we bought it) and since it was the highest interest debt we had not being our primary residence - we already plow $5k a month into the stock market and just liked these extra dollars going into a more conservative "investment".

Well since we bought the property has appreciated significantly (north San Diego county). Between our extra payments, the slide along the amortization table of our primary home mortgage, and the appreciate of the property, I can see a date in the near future where we could sell, pay the long term cap gains, fees, and depreciation claw back and still have enough to pay off the primary house and be debt free.

With full understanding of the potential drawbacks to portfolio growth due to such a conservative move (and not convinced we will consider it seriously at all) what else am I missing? Additionally, is there any ways I can minimize the transaction costs - other than moving my family into a condo for two years -that I'm not thinking about? 15% capital gains on the part of the principle that's actually profit isn't that awful a hit, and it sure is tempting to simplify the equation. Land lording hasn't been bad, just wanted to hear from others with more experience who have looked at this possibility. Thanks.

 

[Choices]

Sold my last rental this past summer and used proceeds to payoff our home. The rental was over 1000 miles from Denver and got to be no fun. It was nice to sell it and rework/stabilize our AA as we are very close to both being retired. This one was paid off, so it freed up some money.
I have had rentals for almost 30 years, now it's time for a different kind of fun.

 

[ducky911]

better do a study on the taxes owed so you will not be surprised. I am in California and had my accountant do a study on if I sold a rental...Tax would be 30% of the sales price minus the depreciated value...ouch..

 

[Bruceski44]

The two ways to avoid paying through the nose upon sale are:
1. Make the rental your primary residence for two years whereupon gains up to $500,000 are excluded from taxation. ( I think I have the amount correct...) Maybe that's what you meant when you said ..."other than moving my family into a condo for two years..." I looked into this before selling our condo which was only 5 minutes from home. I mean would the IRS really be able to say which was our primary residence? It turns out that you must take steps beyond just picking up your mail there. I was afraid the IRS might interview the neighbors and catch me out, so I took option #2.
2. Sell and roll the proceeds over via 1031 tax-deferred exchange into another real estate investment. This won't pay off your primary residence, but your rental income might just pay the mortgage for you. The replacement property must be "like kind" but a REIT investment might meet that requirement which would provide you hassle-free income. In addition, you can continue rolling over via 1031 for your lifetime and your heirs will get a step-up in basis upon your passing, so all those gains and depreciation would never be taxed. This is what we did, choosing a DST investment for the completely passive, reliable cash flow. For an example, look at Capital Square Realty Associates. You could also get into an LLC structure via crowdfunding or RegA+ portals.

I realize neither of these are really what you asked about, but I always try to avoid losing more money to taxes and always try to provide more value to my heirs.

As Jason Parker (Sound Retirement Planning podcast author) says "It's your cash flow which will determine your lifestyle in retirement, not your net worth."

 

[DrBrisket]

better do a study on the taxes owed so you will not be surprised. I am in California and had my accountant do a study on if I sold a rental...Tax would be 30% of the sales price minus the depreciated value...ouch..

The two main implications on your FIT are the depreciation recapture tax and capital gains. A (hopefully minor) secondary implication is bumping up your AGI which can cause problems with phaseouts/reductions in other items that lower your tax liability. Note, I am NOT an accountant, but have been working through the numbers to decide if/when/how we want to liquidate some rentals that we have owned for many years. A tax accountant familiar with rental properties should be consulted to check on your own personal situation. If you don't already have an accountant, talk with a at least two to see if you get the same answer. In my case, the first one I consulted really flubbed up a back of the envelope depreciation recapture tax calculation.

For a property that has been held for a long time, the depreciation recapture tax can be a large, unexpected & unwelcome addition to your tax liability.

Suppose you bought a rental house for $100k with the land worth $20k and the building worth $80k. After 10 years, the allowable depreciation (over a 27.5 year depreciation schedule per the IRS), is $80k/27.5*10 =$29k. The depreciation recapture tax is $29k * 25% = $7K.

If you sold the rental house for $150k, the capital gains would $150k - $100k = $50k. Assuming you are paying 15% long-term cap gains rate, the tax is $50k * 15%= $7.5k.

Total tax due on the sale of the rental property (not including secondary concerns mentioned earlier) = $14.5k.

So, in essence, you are paying $14.5k/$50k = 29% tax rate on the $50k "gain" in this example.

 

[pjigar]

The two ways to avoid paying through the nose upon sale are:
1. Make the rental your primary residence for two years whereupon gains up to $500,000 are excluded from taxation. ( I think I have the amount correct...) Maybe that's what you meant when you said ..."other than moving my family into a condo for two years..." I looked into this before selling our condo which was only 5 minutes from home. I mean would the IRS really be able to say which was our primary residence? It turns out that you must take steps beyond just picking up your mail there. I was afraid the IRS might interview the neighbors and catch me out, so I took option #2.
2. Sell and roll the proceeds over via 1031 tax-deferred exchange into another real estate investment. This won't pay off your primary residence, but your rental income might just pay the mortgage for you. The replacement property must be "like kind" but a REIT investment might meet that requirement which would provide you hassle-free income. In addition, you can continue rolling over via 1031 for your lifetime and your heirs will get a step-up in basis upon your passing, so all those gains and depreciation would never be taxed. This is what we did, choosing a DST investment for the completely passive, reliable cash flow. For an example, look at Capital Square Realty Associates. You could also get into an LLC structure via crowdfunding or RegA+ portals.

I realize neither of these are really what you asked about, but I always try to avoid losing more money to taxes and always try to provide more value to my heirs.

As Jason Parker (Sound Retirement Planning podcast author) says "It's your cash flow which will determine your lifestyle in retirement, not your net worth."

#1 is now prorated for the duration of actual stay out of the total ownership period.

3. Sell as owner financed property so that your taxable yearly income is below 0% capital gains threshold. If structured properly, you can get the gains out tax free and pay tax on interest income.