As our regular readers know, we just sold our 4-plex and a rental home. The good news is we made a profit on both these transactions, but the bad news is we’re going to have a hefty tax bill next April. The rental home in particular has quite a bit of gain because we had it since 2000. It was our primary residence until 2007 when we moved to our current condo. One way to defer paying the tax is to use the IRS 1031 exchange and I thought we’d go over it in detail today.
Rental Home History
Here is the history of our rental home. We purchased the home in 2000 for $210,000 and it was our primary residence until 2007*. We rented it out when we moved to our condo because we wanted to try being a landlord. All in all, it has been a good experience, but the main problem is that the home is 30 minutes away by car. It’s a pain to drive out there every time there is a problem. We had a nice family in the place for 5 years, but they refused to pay higher rent and moved out earlier this year. It was also a good time to sell because the Portland housing market is doing pretty well.
*This house was rented since 2007 so it’s not qualified for the 121 exemption. That exemption means you don’t have to pay tax on any profit up to $500,000 if the home is your primary residence for at least 2 out of the last 5 years.
- Purchased price: $210,000
- Depreciation taken: $35,000 (Tax deduction over 7 years.)
- Sale price: $345,000
- Fees: about $20,000
- Profit: sale price – fee – (purchased price – depreciation taken)
- Estimated profit: $345,000 – $20,000 – ($210,000-$35,000) = $150,000
The Tax Problem
At first glance, it might seem like a non issue. The profit is not huge and it will be taxed at the long term capital gain rate of 15%. However, Oregon tax long term capital gain at the same rate as income tax. That’s another 10%! Also, the depreciation taken would be taxed at 25%. Lastly, the capital gain would push our income up quite a bit and we’d lose the child tax credit and various other tax benefits.
Needless to say, this is getting complicated and I’ll have to hire a tax accountant next year. Meanwhile, I plugged this info into 2013 TurboTax to get an estimate. According to TurboTax, we’d have to pay about $45,000 more in taxes next year. That seems really high to me, but I trust TurboTax. $45,000 is a lot of money to send to the IRS and we will try to defer it if we can.
Additional tax in 2015: $45,000 if the 1031 exchange is not successful.
Disclaimer: I’m not a tax adviser so I could be wrong on some of the finer points here.
One way to defer the tax is to take advantage of the IRS 1031 exchange rule. Basically, you can sell your rental and roll all the proceeds into another rental property. You don’t have to pay tax until you cash out at some point in the future. When we close on the rental home, the proceeds is sent to an exchange service company. We’ll work with them to roll everything into a new rental property. As I understand, the replacement property has to be worth more than the previous property. If you receive any money OR reduction in mortgage loan, then you’ll have to pay tax on that amount. It’s a bit tricky so you’ll probably want to work with your tax adviser if you’re thinking about this.
Here are the important dates.
- Closing date: June 20, 2014
- Identification period: August 4, 2014. We have 45 days to identify some replacement properties. We can put as many properties as we’d like on this list.
- Exchange Period: December 17, 2014. We’ll have 180 days to close on one of the properties on the list.
The problem now is the Portland housing market is too hot… The houses sell very quickly and the prices are pretty high. There are only 3 homes for sale in the area we’re looking and there are various reasons why they’re still on the market. Oh well, we’ll give it a try and see how it goes.
Cost: The exchange service company charges $750 to service the fund. If we close on a replacement property, then it will cost another $250 to disperse the fund. So $1,000 total if all goes well.
We also have an upcoming problem with our housing. Currently, we are living in a 2 bed/2 bath 1,000 sq ft condo and it’s getting a little tight. My mom is staying with us for 6-9 months at a time and she is sharing a room with our 3 year old son. That’s not a problem right now, but in a few years, he’ll want his own room. This is another motivation for us to do the 1031 exchange. We can buy a replacement property and rent it out for a few years, then move in at some point. We’ll have to use the replacement property as a rental for at least 24 months for the 1031 exchange to be valid according to the IRS.
The additional motivation here is the possibility of using the $500,000 primary residence exclusion. That rule indicates you can sell your primary residence and won’t have to pay any tax on the profit up to $500,000 (for couples.) My plan is to move into the replacement property and live there for at least 5 years. That way we can avoid the bulk of the tax. We’d still have to pay 25% tax on any depreciation taken when we sell, but I’m fine with that. If we live there for less than 5 years, then the capital gain tax would be prorated. That shouldn’t be a problem because I promised Mrs. RB40 that we’d stay put until Jr. finishes high school if we move to the replacement home. That’s 15 years from now if everything goes according to plan. Of course life never really goes as planned, so who knows how it will turn out.
Anyway, I think it’s fair for us to try to take advantage of this primary residence tax exclusion. We lived in the rental home for 7 years and rented it out for 7 years. Most of the gain was from when we lived there so it seems a bit unfair for us to pay tax on all the gain.
What do you think of this plan? For the experts out there, am I missing anything?
Alternative – We are looking at a small duplex where we can rent one of the units as a vacation rental when my mom isn’t here.