Converting Primary Home to Rental but maintaining $500K Exclusion

[Ncc1701]

Hi All,

After I FIRE late next year, I and DW want to spend most of the time in Florida and would like to rent out our primary home in NY.

However we have a large unrealized gain on the primary home and obviously we don't want to lose the $500K (Section 121) capital gain exemption. So Every 2-3 years or so, I would tell the tenants they have to move out and we will then switch our primary home to NY for two years just to "reset the clock" so to speak. After the clock is reset, I would look to rent it out again and then repeat the process two years later.

Is this a sound strategy? Are there risks I'm not thinking about? Anyone else done this? Thanks for any input!

 

[aja8888]

What do you report to the IRS when it stops being a rental and you have no future use (for a couple of years, in your case) as a rental? I'd suggest you see aa RE attorney on this.

 

[pb4uski]

Why not sell it? No questions that gain is tax-free.

 

[Ncc1701]

Why not sell it? No questions that gain is tax-free.

It would not be easily replaceable if we decide FL isn't for us. It's a young house in a high demand, densely populated area, I'm thinking that future appreciation could be more than whatever portfolio I invest the proceeds in.

 

[Montecfo]

Hi All,



After I FIRE late next year, I and DW want to spend most of the time in Florida and would like to rent out our primary home in NY.



However we have a large unrealized gain on the primary home and obviously we don't want to lose the $500K (Section 121) capital gain exemption. So Every 2-3 years or so, I would tell the tenants they have to move out and we will then switch our primary home to NY for two years just to "reset the clock" so to speak. After the clock is reset, I would look to rent it out again and then repeat the process two years later.



Is this a sound strategy? Are there risks I'm not thinking about? Anyone else done this? Thanks for any input!

Asking for trouble I'd say.
Plus much easier in theory than in reality.

 

[FlaGator]

It would not be easily replaceable if we decide FL isn't for us. It's a young house in a high demand, densely populated area, I'm thinking that future appreciation could be more than whatever portfolio I invest the proceeds in.

I’ve owned homes since the early 80’s and been through more than one complete real estate cycle. Also. worked in a business that was directly tied to that cycle.

When I do the math, there are better long-term returns in the market than residential RE. However, if life works your way on the buy/sell timing, returns can be great. Just like the equity market.

If you’re not sure if relocating would stick, I would force myself to make a decision within the window to preserve your tax advantage without any games.

There is also the POV of “when I’m done, I’m done and not looking back”.

A lot to consider. IME, I wouldn’t hang on to the NY house expecting prices will go up in a meaningful amount from here soon.

 

[Philliefan33]

When the house becomes a rental, you need to take depreciation. (Even if you don’t take the depreciation, when you sell the house you will be subject to the depreciation recapture for the amount you should have taken).

The depreciation recapture gets taxed at (usually?) higher rates than capital gains. (It did in our case when we sold a rental). So depending on your actual numbers you may be trading exempt $ or capital gains $ for a higher tax rate on the depreciation recapture.

 

[clobber]

Is this a sound strategy? Are there risks I'm not thinking about? Anyone else done this? Thanks for any input!

You really need to make sure you understand the concept of non-qualified use. I am not an expert, but it is my understanding that these periods of non-qualified use (when you have it rented out) will likely reduce your gain exclusion. According to IRS Pub 523:

"Non-qualified use means any period after 2008 where neither you nor your spouse (or your former spouse) used the property as your main home, with certain exceptions."

You can't just move back into the property to "reset the clock." The first exception sates:

Any portion of the 5-year period ending on the date of the sale or exchange after the last date you or your spouse (or former spouse) used the property as your main home

So this says that some of the time AFTER the last time you live in the house and before you sell is an exception. But the time you rent it out and before the last time you live in it is not an exception. There is a good example is this publication.

It is a very complicated topic. Depending on the numbers involved, you still might be able to get the maximum exclusion even with non-qualified use. This can happen when there are large gains. There is a good description in this article.

 

[Ncc1701]

You really need to make sure you understand the concept of non-qualified use. I am not an expert, but it is my understanding that these periods of non-qualified use (when you have it rented out) will likely reduce your gain exclusion. According to IRS Pub 523:



You can't just move back into the property to "reset the clock." The first exception sates:



So this says that some of the time AFTER the last time you live in the house and before you sell is an exception. But the time you rent it out and before the last time you live in it is not an exception. There is a good example is this publication.

It is a very complicated topic. Depending on the numbers involved, you still might be able to get the maximum exclusion even with non-qualified use. This can happen when there are large gains. There is a good description in this article.

Appreciate the thorough response...thanks!

 

[jebmke]

Why not sell it? No questions that gain is tax-free.

yes; I certainly would not torque around my life moving back to NY just to get the exclusion. Sell it now, move along with life.

 

[pjigar]

You have 2 years to bank the tax free gains. Better make up you mind in 2 years. If you switch back and forth between primary and rental then that is a road un charted. Talk to an attorney.

Mixing anything muddies the water.

 

[Major Tom]

Besides the possible drawback noted by other posters here, you would also need to ensure that a renter actually does move out when required to, by setting expectations when they move in. What if you're unlucky enough to end up with a problem tenant who decides that they're not going to move out?

Perhaps I'm overthinking this by looking for possible problems, but my approach to most things is to hope for the best, while planning for the worst.

 

[Aerides]

Besides the possible drawback noted by other posters here, you would also need to ensure that a renter actually does move out when required to, by setting expectations when they move in. What if you're unlucky enough to end up with a problem tenant who decides that they're not going to move out?

Perhaps I'm overthinking this by looking for possible problems, but my approach to most things is to hope for the best, while planning for the worst.

In the event the OP does end up renting, I strongly recommend a property manager (and this also further reduces the cash-flow equation). Being several states away means you need someone there to handle issues, both on behalf of the tenant and the owner.

Go to Florida, leave the house vacant with a house minder doing pop ins, and then after a year or three decide if you want to be snowbirds or move or not.

 

[OldShooter]

I'm in the "too complicated and risky" camp. Another factor is residency issues with the states. I have read that NY is particularly aggressive about this, working hard to collect taxes from people who have moved to places like FL. Checking things like where your dentist lives, where your pet's vet is, where you bank, etc. Much more than just counting the days you are physically in or out of state. I suggest you check into this before making any decisions.

 

[38Chevy454]

In addition being a landlord from 1500 miles away is going to be a PITA. Just sell it now, avoid the long distance landlord issues and potential tax complications. I can't imagine wanting to move back to NY. Especially after living in warmer climate and LCOL area. I do understand there are nice areas in NY to live, but you still have dominating politics of NYC affecting the whole state. Get out completely and be happy in your new place.

 

[jollystomper]

It would not be easily replaceable if we decide FL isn't for us. It's a young house in a high demand, densely populated area, I'm thinking that future appreciation could be more than whatever portfolio I invest the proceeds in.

In my view, before you look at the complexities of renting others have pointed out, I would settle this decision first. Find an area in Florida you are considering, and rent there for a while (even for part of the year) to see if that is 100% what you want. *Then* decide if you want to sell (recommended) or rent your NY home.

 

[meierlde]

It should be noted that if you loose money on a rental at market rates that loss is accumulated and when you sell these losses reduce the gain. Secondly depending on the tax bracket depreciation recapture is taxed at a max rate of 25%. (may change in 2026). If you make money you pay taxes on that immediately.



As to the tax angle, Florida has no state income tax, so if you stayed a NY resident until you decide, that could avoid the issue. (or at least filed the NY state return but changed driver license state)

 

[MarieIG]

In my view, before you look at the complexities of renting others have pointed out, I would settle this decision first. Find an area in Florida you are considering, and rent there for a while (even for part of the year) to see if that is 100% what you want. *Then* decide if you want to sell (recommended) or rent your NY home.

This ^^^.

I briefly considered being a landlord (with the former marital residence) but certain risks being faced by landlords decided me against it.

 

[MarieIG]

In the event the OP does end up renting, I strongly recommend a property manager (and this also further reduces the cash-flow equation). Being several states away means you need someone there to handle issues, both on behalf of the tenant and the owner.

Go to Florida, leave the house vacant with a house minder doing pop ins, and then after a year or three decide if you want to be snowbirds or move or not.

I'm in the snowbird camp.

DF had an out of state rental - "back in the day." We lived in NY and he owned a single family in Florida. He had a management company, but it still was a royal pain. Tenants snuck in dogs who destroyed the carpet (the management company needed money to have it replaced); plumbing problems (more money needed); appliances failing (more money needed); tenants didn't pay (the management company needed money for their lawyers); and upon one occasion the FBI was looking for one of the tenants (he was on a wanted list). I recall when DS#1 was born, DF was in Florida fixing up the place after one of the trashing sessions due to the cost quoted by the management company. He eventually sold the place as it was too much trouble. I'm not saying that it can't be smooth sailing for OP, but it is not necessarily so.

 

[calmloki]

I'm in the snowbird camp.

DF had an out of state rental - "back in the day." We lived in NY and he owned a single family in Florida. He had a management company, but it still was a royal pain. Tenants snuck in dogs who destroyed the carpet (the management company needed money to have it replaced); plumbing problems (more money needed); appliances failing (more money needed); tenants didn't pay (the management company needed money for their lawyers); and upon one occasion the FBI was looking for one of the tenants (he was on a wanted list). I recall when DS#1 was born, DF was in Florida fixing up the place after one of the trashing sessions due to the cost quoted by the management company. He eventually sold the place as it was too much trouble. I'm not saying that it can't be smooth sailing for OP, but it is not necessarily so.

Over 35 years as a landlord here and MarieIG has it right. If you want to sell the place - or move back in - do not rent it out. It will NOT be returned the way you left it. It will cost more to restore it than you make. Doubt that any rent you receive, after paying maintenance, restoration, depreciation recapture on sale and on and on would be worth it. Add in the tax wrinkles and tenant or management management? Pay the NY state tax and hold the house for a while while you try out Florida or sell the house now and roll the dice.

We snowbird between Oregon and California and leave each place vacant for 1/2 the year. We declared residence in California and may sell our California house at some point and re-declare Oregon residency because we have more of ourselves in this house - but it's been 13 years now...

 

[wannabe]

Vacant house insurance...

is much more expensive than for a furnished, occupied house. Most home insurance policies will cover for 30-60 days, but after that you need a different policy. I am going through that now and it is a real PITA.

 

[Ncc1701]

Thanks for all the responses. Some real good advice here. I think the best thing to do is not rent it out and maintain NY residency even if we spend most of our time in Florida. I may be paying state income tax on some pension and investment income but that is minor compared to the capital gains tax.