What are strategies for avoiding capital gains on the sale of a rental house?
Me and my wife purchased a home in the 1980s, used it as our primary residence for several years, and have been renting the property as an investment since 2010. We want to sell the home now, and split the profits between our children, so that they can use the money for their own down payments. If one of my children is added to the title and lives in the home for two years, will the sale of the house be exempt from capital gains taxes? Does the child need to own the property for at least five years, and live in the property for two years? We are on the title too; do we have to make the home our primary residence too? how can we avoid capital gains taxes in this situation?
As an owner of investment real estate, you'e decided to sell. But unlocking the value and turning it into cash can also result in a large tax bill especially if your asset has appreciated since your initial investment back in the 1980s.
First things first: Since you no longer occupy the property as your primary residence, you cannot use the Section 121 exemption of $500,000 over basis (married filing jointly) to shield yourself from a capital gain tax liability.
Second, you could add someone to the title and that person would need to occupy as his primary residence for two of the last five years. So, no, he wouldn't need to live there for five years.
Third, if you choose not to live in the property while your son does, you each must apply Section 121 individally. If you and a joint owner other than your spouse sell your jointly owned home, each of you must figure your own gain or loss according to your ownership interest in the home. Each of you applies the rules on Section 121 found in IRS Publication 523 on an individual basis. So, unless you move back into the property for at least two years out of the past five, then you won't be sheltering any of the gain for your portion of the property.
Now, you may think it's hopeless and you should just pay the tax. While that is an option there are innovative strategies available to you if you want to lower your income tax bill when you sell and investment property (or business for that matter).
Typically, when a business or real estate owner sells they will need to deal with capital gains tax, state taxes, depreciation recapture and, in some cases, the alternative minimum tax. But through savvy tax and estate planning, you can take advantage of opportunities in the tax code to minimize your current tax liability while allowing you the flexibility to control the sale proceeds.
Real estate investors can use a 1031 Exchange, a provision of the Internal Revenue Code which allows an owner to relinquish property and replace it with a similar type of asset without recognizing gain and deferring taxes.
While a 1031 Exchange offers tax deferral, it is ONLY a replacement option. You must replace income-producing property with other income-producing property but you may not receive cash upon the sale without paying tax on the gain.
Other options offer even more flexibility to sell highly appreciated assets like stock in a privately-held business or ownership of residential rental or commercial real estate while also controlling use of the cash that is freed up from the sale. These include a strategy like a “monetized installment sale” (M453) previously referred to as a “collateralized” or C453 installment sale.
This option is based on the installment sale rules contained in Section 453 of the Internal Revenue Code. This offers you options to salvage a failed 1031 Exchange which can occur if a seller of a property cannot locate a suitable replacement property or a closing fails to occur within the 180 days required by law.
In addition to deferring taxes while freeing up cash that can be used today, it also offers you a great estate planning tool. This is because of the discount that an estate receives for something called ‘lack of marketability.’
Monetized Installment Sale (formerly Collateralized Installment Sale)
Another variation on the standard installment agreement is a monetized installment sale previously called a ‘Collateralized Installment Sale Agreement’ and sometimes referred to as a C453 installment sale. This strategy has a longer track record.
There are two distinct transactions as part of this strategy. The seller agrees to sell the property or a business to a dealer who resells the property to a final buyer using the original terms. Separately, the seller receives a limited-recourse loan from a lender typically equal to 95% of the resale proceeds. The seller can then take the non-taxable loan proceeds and reinvest however he sees fit. Proceeds can be used to pay off debt, invest in another business or property or in securities without the limitations of a 1031 Exchange. The dealer receives cash from the final buyer in a lump sum or through a lump sum plus one or more installments which offloads the risk of an installment sale onto the dealer. The lender’s loan to the original seller is repaid by automatic payments from the money that the dealer pays to the seller on the installment contract.
Unlike a 1031 Exchange, these installment sale variations can be used for the sale of more than just real estate. It can be used to handle the sale of an interest in an operating business as well offering more flexibility to an investor.
Ultimately, this strategy allows a seller to defer taxes while investing the proceeds today to generate replacement income and cash flow (or to use however the owner deems fit). Clients win by deferring taxation of gains and by having full control of the wealth unlocked from the sale of the highly appreciated asset. In the case of a monetized installment sale (or C453 sale), the client has full control of non-taxable loan proceeds. Clients also win by having more flexibility to invest in other property, businesses or securities that may produce higher income over time than the business or real estate being relinquished. As the saying goes, a bird in the hand is worth more than a bird in the bush and with these strategies investors have more in hand to invest.
You can read more about this and watch a video that helps explain the concept here.
You should see a CPA on this, but my understanding is you cannot avoid the capital gains because you have not lived in the home for the past five years. If your son moves into the home that is a gift and it will most likely exceed the annual gift tax exclusion. Captial gains are taxed at a much lower rate than normal income taxes and if you are in a 15% tax bracket the capital gains rate is 0%. If you are in a higher bracket the capital gains taxes will be 10% or 20%. Like I said you should consult a CPA.
The 2 out of last 5 years is to turn that investment property into a primary residence in which you could then receive the $250k (Single) $500k (Joint) tax exclusion. Good thing the tax bill didn't increase that to 5 years out of 8.
Other than that, There is really no way to avoid cap gains on an investment. Just like you cannot avoid income taxes. But you can defer taxes. The only way to defer is a 1031 exchange. But it would have to go back into an investment property or REIT. does not sound like that will work for you.
Adding kids on deed or selling at a reduced amount is a completed gift (if sell the difference between what you sold and FMV by appraiser would be gift amount). Gifting to kids could help someone who is worried about estate taxes and getting that asset out of your estate or having kids be able to take hit/exclusion on appreciation of the property. But does not help with capital gains today as you would just be transferring the low cost basis to them to when they sell it. If they are in a lower tax bracket and could qualify for the 0% cap gains then you may be on to something. You would have to file gift tax return, but as long as it has not exceeded life time gift exclusion which is over $5MM, you would not pay gift tax.
But I agree, you should always consult with CPA or tax attorney if trying to consider a method to reduce taxes. Also always consider the cost of the strategy. It could cost more than just taking the hit on the capital gains.