Sorry to write about the rentals again today. It’s just consuming all my attention and I’m having a hard time thinking about anything else. We decided to put our rental home and 4-plex up for sale to take advantage of the HOT real estate market. I know we’d have to pay tax on the gain, but I didn’t realize just how much tax we’d have to pay.
A Big Tax Bill
I just finished our tax return with 3 days to spare. Whew! This year we don’t have to pay much tax at all because we came in under the 15% tax bracket as planned. The upshot of this is our dividend income last year was tax free. Yes! That’s what I love about dividend investing. If you file as married jointly and your taxable income is under $72,500, then your dividend income is not taxed.
Once our tax was done, I modeled how much tax we’d have to pay by putting in the projected sales info. Well, imagine how you would feel if next year’s tax bill will be $47,000 higher (federal and state combined). With the capital gain from the rentals, our income would shoot into the 33% tax bracket and we’d have to pay a lot more tax next year.
Here is the info on the rentals.
|Rentals||Cost||Projected Sale Price||Mortgage Owed||Taxable Gain||Additional Tax next April|
This is assuming we sell the 4-plex first, then the rental home. The income would get added on top of one another and push us up the tax bracket. I can stomach selling the 4-plex and pay the tax, but the rental home just increases our taxable income too much. It’s almost cheaper to just hold the house for 2 years, then sell it as a primary residence to avoid such a huge tax bill.
Yeah, I know. It’s a first world problem, but that is A LOT of tax. So what are our options?
1. Sell our condo and move into our old house for a couple of years.
This would be the most financially beneficial move. Our old house is the perfect size for us right now. If we live there for 2 years, we won’t have to pay tax on the capital gain when we sell (up to $500,000 gain for a married couple.) We don’t owe much mortgage and our monthly housing cost would reduce quite a bit. We also won’t have any gain from selling our condo, so that won’t affect the tax.
However, the house is not conveniently located. Mrs. RB40 would have to commute for over 2 hours per day on the light rail. Right now, she gets home around 5:30 pm and it’s perfect. If we moved back to the suburb, she’d get home around 6:30 pm (and later when she works late) and we won’t get to spend as much time as a whole family. That’s a huge problem.
We also like living in downtown Portland. It suits us much more than the suburb.
*update* The new rule states that the profit will be prorated depending on how much you used the home as a primary residence. So if we live in the home for 2 out of the last 5 years before we sell it, then we will still have to pay tax on 60% of the gain. We also have to pay 25% on any depreciation taken.
2. Just sell the 4-plex. Keep the house and the condo.
As mentioned above, it’s almost cheaper to just keep the house and convert it to our primary residence than to pay the additional $30,000 in tax. We could live in our condo during the weekdays and live in the house during the weekends and vacations. For tax purpose, the house will be our primary residence and the condo will be our second home.
This would eliminate the commute problem for Mrs. RB40. We’d have the best of both worlds. Of course, it would be painful to pay 2 mortgages and utility bills. Our monthly housing cost would be nuts and our monthly cash flow would be shot to pieces.
3. 1031 exchange the rental home
Basically, you can defer the capital gain tax if you roll the money over to another investment property. I did some research a few weeks ago and discounted it mainly because we have 2 rental properties. Doing a 1031 exchange would be a lot of headache for us for the following reasons.
Timeline – We’d have to buy a new home in this hot market and the timeline is tight. You have 45 days from the closing date of the first property to identify a new home and 180 days to close.
The right property – It’s going to be tough to find the right property right now. The inventory is extremely low in our area. Mrs. RB40 is reluctant to buy if it’s not the perfect place, or at least, close to it. We’d rent it out for a few years and then move in. The plan is we’d live there until RB40 Jr. graduates high school in 15 years or so.
Target value – The target value needs to be equal or greater than the properties you’re exchanging. Basically, you have to pay tax on any money you receive from the deal OR any reduction in mortgage. If we exchange both properties, then we’d have to find a place that cost $750,000 AND get a $300,000 mortgage. I don’t want to get a big expensive home because we’d have to pay more property tax, utilities, and insurance.
Mortgage – Now that I’m self employed, I’m no longer a good customer for the banks, especially for investment properties. I’ll need to go talk to my bank and see what they can do for us. I doubt they would lend us $300,000 for a rental property. However, I’m pretty sure we can borrow $70,000. This is why I think it’s probably better to do the 1031 exchange on only the rental home.
Landlord – One of the reasons why I’m selling is because I’m tired of being a landlord. Do I really want to deal with another rental? I’ll definitely hire a property manager if we can pull off the 1031 exchange.
I talked to a 1031 exchange specialist and she told me it will cost about $1,000 to do the exchange for one property. The cost is a little more as you add more properties to the exchange. That’s not too bad if it all works out.
I think the best option for us right now is to do the 1031 exchange only on the rental home. We’d avoid the biggest tax hit and it would be easier to find the right replacement property. If we can’t find the right property in time, then we’d just bite the bullet and pay the big tax bill next year.
4. Other alternatives
There are more hair brained alternatives that I already gave up on.
- 1031 exchange both properties into an owner occupy 4-plex nearby. More landlord fun…
- Move to rental home and rent out condo. Long commute and probably won’t make any money with the condo rental.
- Just sell everything and move to Santa Barbara. Except Mrs. RB40 can’t find a job there…
- Keep both rentals. Probably a good idea financially, but I don’t want to be a landlord right now…
- Sell the 4-plex and keep renting the rental home.
- Just pay the tax and be done with it. This isn’t a bad option at all. We’ll pay a big tax bill next year, but after that our tax bill will be reasonable for years to come.
- Any suggestions? I’m losing serious sleep over this whole process.
So that’s why I’m all stressed out lately. At this point, I’m going to go with option 3 and do a 1031 exchange just with the rental home. It will be a lot of work and more stress, but it’s the one that make the most sense to me.
Tax is why it’s better to think long term with investment properties. Whenever you sell, you’ll have a huge tax bill and all kind of fees to deal with. It’s better to keep it and enjoy the rental income if you can handle being a landlord. I’m open to suggestions so let me know what you think we should do.
Photo credit: flickr fd
Disclaimer: I’m not a tax expert so my info might be wrong.