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I bought my first house in May 2012. I moved into my second (current) house in November 2014. After I moved out of my first house, I began doing repairs on it, and started renting it out around May of 2015. So I lived in my first house for about 2.5 years and have been renting it for about 1.5 years. The house has almost doubled in value. I bought it foreclosed for 70,000 and its worth around 130,000. I really want to stay in the rental property business for a while, but I know there is a law/rule/exemption for selling a house if you've lived in it for 2 out of the last 5 years, which I have. If you meet that requirement, you don't have to pay capital gains on the profit from the sale.

If I sold the house now I wouldn't have to pay capital gains, but I would then want to buy another house as a rental. Also, right now I don't even get to depreciate the full value of the house since i bought it at 70,000. So the question is, is there any way to keep my current rental and avoid paying capital gains if/when I sell it later in life and maybe also depreciate based off the home value instead of purchase price? Could I sell the house to myself or something? I don't know. Any idea what the best thing to do here is? I really don't want to sell the house, just to buy another, but it would save me around $9000 in capital gains. Am I missing something?

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  • Rutherford County, TN fyi
    – Hoopdady
    Jan 5 '17 at 20:20
  • @NathanL Not that great with metaphors, but if you're saying don't let taxes deter me from investing, I absolutely agree. Its not deterring me, I'm just trying to figure out what gets me the greatest return.
    – Hoopdady
    Jan 5 '17 at 20:47
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    Everything that you depreciated so far will be recaptured as income - it is separate from your 2 in 5 year exemption (in the US this is called "section 1250 gains"; straight dope here: irs.gov/publications/p544/ch03.html)
    – user662852
    Jan 6 '17 at 2:15
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    Cannot upvote @user662852 's comment enough. You will almost certainly be paying tax if you sell. Make sure you figure out with a good accountant what you will owe.
    – Jared Smith
    Jan 6 '17 at 14:39
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Don't let the tax tail wag the investment dog.

There is risk in exchanging this (known) property for another (unknown) property. That risk may be more than $9000 worth of risk. Tax considerations are important, but most important is that your investments make money. If you intend to continue as a landlord, you had better be sure you are finding a better deal elsewhere if you are going to trade this property up.

I should also mention that you have a 5 year window in which you need to have lived in the home for 2 years. You have time and might be able to sell for a higher price if you wait a little longer.

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  • 5
    money.stackexchange.com/search?q=wag+the+dog
    – NL - Apologize to Monica
    Jan 5 '17 at 21:02
  • 21 of the 30 results quote my use of that phrase, I'm glad you like it, as I think the underlying sentiment is so important. Transaction costs on the sell/buy combined with new cost to fix up and get a new tenant can easily wipe out that saved tax.
    – JTP - Apologise to Monica ♦
    Jan 6 '17 at 18:07
  • @JoeTaxpayer, yeah, I've heard it elsewhere too, but I realized after I used it that I'd heard it a lot around here. I have been more active posting with the winter bash, but usually I frequent this place because I like the exposure to everyone else's good ideas.
    – NL - Apologize to Monica
    Jan 6 '17 at 18:21
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Your question is best asked of a tax expert, not random people on the internet.

Such an expert will help you ask the right questions. For example you did not point out the country or state in which you live. That matters.

First point is that you will not pay tax on 60K, its expensive to transact real estate, so your net proceeds will be closer to 40K. Also you can probably the deduct the costs of improvements.

You implied that you really like this rental property. If that is the case, why would you sell...ever? This home could be a central part of your financial independence plan. So keep it until you die. IIRC when it passes to your heirs, a new cost basis is formed thereby not passing the tax burden onto them. (Assuming the property is located in the US.)

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    This. If you bought a cheap foreclosure, I'm certain you put a lot of money into improvements -these effectively increase your cost basis. Don't lose track of that. We did that with our house - bought for close to half price, but then put in nearly 2/3 of the difference in improvements, meaning it's only really gained ~15% of value.
    – Joe
    Jan 5 '17 at 22:21
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While it may not be your preferred outcome, and doesn't eliminate the income, in the event you find yourself in the path described here you have a way to defer gains to the future.

but I would then want to buy another house as a rental

If you sell this house and buy another investment property (within strict time windows: 45 days to written contract and closed in 180 days), you can transfer your basis and defer your gains via what is called a 1031 like-kind exchange

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    How is this better than just staying put? OP would like to get the 2 year cap gain exclusion, not just defer tax.
    – JTP - Apologise to Monica ♦
    Jan 6 '17 at 2:24
  • I see, I misread the "if...then" which I quoted as a non-conditional motivation. I'll expand on the answer
    – user662852
    Jan 6 '17 at 2:37
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Just brainstorming here, but my gut feeling is it should be possible to sell your home to yourself with the sole purpose of resetting your basis. Taken at face value it feels illegal, but since I think we all would agree that you could sell your house to a third party and purchase the identical house next door for the same price (thus resetting your basis), why can't you purchase the same home right back? If one is legal, it seems odd for the other not to be. That being said, I have no idea how to legally do it. Perhaps you truly need a third party to step in which you sell it to, and then buy it back from them sometime in the future. Or perhaps you could start an LLC and have it purchase your home from you. Either way, I highly suggest finding an expert real estate attorney/accountant before attempting this, and don't be surprised if you get multiple opposite opinions. I suspect this is a gray area which will highly depend on how tax "aggressive" you are willing to be.

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What you are looking for is a 1031 exchange.

https://www.irs.gov/uac/like-kind-exchanges-under-irc-code-section-1031

Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

You may also sell your house for bitcoin and record the sales price on the deed with an equal or lesser amount that you bought it for.

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    I'm fairly sure the last suggestion is illegal, and called tax evasion.
    – Tim
    Jan 6 '17 at 2:36
  • The IRS considers bitcoin property so make of that what you will.
    – Chloe
    Jan 6 '17 at 2:44
  • okay so not illegal, but it doesn't help here because then he would have to pay capital gains when he sold the bitcoin?
    – Tim
    Jan 6 '17 at 2:48
  • Any venture into the bitcoin marketplace on the scale of real estate should definitely be preceded by consultation with qualified financial, tax, and legal professionals. (Not to suggest there'd be a risk of violating any law, merely that you want to make sure you know how your legal rights and risks may differ when involving this currency, which is still in its legislative infancy). Using bitcoin for day-to-day purchases, or even a car, is quite different from doing so on this kind of scale, so you'd really want to educate yourself first.
    – Dan Henderson
    Jan 6 '17 at 14:25

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