Taxes and the Sale of Your Rental House
Whether you own a single rental home or you’ve built up a real estate empire during your years of PCS-o-rama in the military, you might need to sell a rental home at some point. You know that Aunt IRS will want a chunk of your gains, but how much? And, is there any way to signature manage your tax bill?
Section 121
One of the key benefits of homeownership is that, per Section 121 of the Internal Revenue Code, taxpayers can exclude from reportable income up to $250K/$500K (single/married) of capital gain when selling a primary residence.
If you’re familiar with this enormous benefit, you’ve likely heard that the major requirement is living in the home for at least 2 of the last 5 years. As with all things IRS, it’s never quite that simple. Here are the other factors you need to know:
- Every 2 Years: You cannot have excluded gain on another home within 2 years
- Spouse Frat: If your spouse used the exclusion within 2 years, you cannot jointly use it within 2 years
- Example: Miss Raines sells a home and excludes gain in 2020 then marries Mr. Olds in 2021 and moves into his home. In late 2021 Mr. and Mrs. Olds sell the home Mr. Olds brought to the marriage. Olds would only be able to exclude up to $250K since his spouse had used her benefit within 2 years.
- Less than 2 Years of Residence: If you have to PCS in under 2 years, you may be able to prorate the benefit.
- Example: Mr. & Mrs. Olds buy a home north of the FEBA in Las Vegas in July 2006. Olds gets orders to ACSC starting July 2007 and they sell the home for a $300K gain. Because the move was forced by work, they’ll multiple the maximum potential gain of $500K by 50% (really, it’s 365 days ÷ 730 days) and be able to exclude $250K gain but not the whole $300K. They will pay capital gains tax on $50K (and probably need to find a way to own it for a year a day so it’s the long-term rates).
- Periods of Non-Qualified Use: This issue gets confusing quick, but it distills to this:
- If you live in the home for 2 years before converting it to a rental, you’re eligible to exclude up to $250K/$500K (single/married).
- If you buy the home to rent it out first, then live in it for 2 years before selling it, the gain attributed to the days of rental use are not eligible for the exclusion. This is not common for military slum lords, but it can catch you by surprise if you’re buying lots of property.
2 of 15 for Military
What many tax professionals do not know (or remember if they haven’t dealt with it recently) is that Section 121 has a callout for Active Duty military (and some other specific government employees). The wording is also confusing, but essentially, active military only need to have lived in the home for 2 of the last 15 years in order to exclude gain.
The same rules apply as above, and things could get really sticky with periods of non-qualified use.
Example: Mr. and Mrs. Olds buy and live in a home from 2010 to 2012 before PCS’g to the 5-sided wind tunnel from 2012 to 2015 and renting out the home. In 2015, the Olds family returns to the home until 2017 at which point, they PCS again and rent the home until 2020.
In this case, the first rental period would constitute a period of non-qualified use. Gain attributed to that period would not be eligible for exclusion, however gain from two periods of personal residence and the second rental episode would be eligible.
**Warning**
If you prepare your own taxes, or use a tax professional that isn’t familiar with the military “2 of 15” rule, you might leave the tax man a tip. Tax software doesn’t always catch these situations and most tax preparers don’t primarily serve military clients.
Depreciation Recapture
Families that get a fat check after selling a rental home often experience a bit of shocked face when they realize that part of the gain is always taxable.
Recall that one of the key benefits of owning a rental property is deducting depreciation each year. That deduction comes home to roost at the sale when Aunt IRS taxes gain up to the amount of depreciation taken.
This tax is often called depreciation recapture and it’s taxed at your marginal tax rate up to a maximum of 25%.
Example: Mr. and Mrs. Olds (active duty) buy a home in 2010, live in it 2 years and then rent it out for 7 years before selling it. The value of the home (not including the land) when they placed it into rental service was $275,000.
Residential real estate must be depreciated by a “straight line” method over 27.5 years, so $10,000 per year for each of the 7 years the Olds family rented the home out.
The Olds sell the home for $700,000. Including improvements and depreciation, let’s assume their basis in the home is $300,000 and therefore they have a $400,000 gain. The first $70,000 of the $400,000 gain will be taxed at their marginal rate up to 25%, and the remaining $330,000 is eligible for the exclusion.
Tactics for Military Real Estate Moguls
Families own real estate for lots of reasons including:
- Building a portfolio of properties to provide cash flow
- Diversifying away from equities and fixed income assets
- Inability to sell without a loss at PCS time
- Desire for appreciation with intent to sell at a future day
- It just sort of worked out that way…
Like most things in life, a portfolio of rental properties can be easier to get into than out of, especially when calculating the tax costs. Thus, it’s never a bad time to plan your branches and sequels for divesting of properties in a tax-efficient manner.
Tactic 1: Use the Section 121 “2 of 5” exclusion (2 of 15 for active military). For active military, really this just means planning to sell prior to separation or retirement. If the gain is going to be over $250K/$500K (single/married), perhaps enjoy the extra gain and don’t let the tax tail wag the investment dog?
Tactic 2: Sell one every 2 years. Recall that the exclusion can only be used every 2 years, so if you have multiple properties, you’ll need to string out the sales to try to maximize gain, afford the tax on depreciation recapture, and sell them prior to separation/retirement while you’re still on active duty.
Tactic 3: Pay long-term capital gain tax. Assuming that you own the property more than 1 year, if you don’t qualify for the Section 121 exclusion, you’ll still probably qualify for the favorable 15% long-term capital gains rate on the gain that isn’t affected by depreciation recapture.
Tactic 4: Like-Kind Exchange. Also called a 1031 Exchange (based on the section of the Internal Revenue Code), this maneuver allows you to defer recognition (and therefore taxation) on gain if you acquire another investment property. 1031 Exchanges have lots of rules and you MUST plan one in advance if you hope to execute it effectively.
Key requirements are:
- Must identify new property within 45 days of closing on your old property
- Muse close on the new property with 180 days of closing on your old property
- Must use a qualified 3rd intermediary to handle the transaction and escrow funds
Tactic 4B: Continuous Like-Kind Exchanges. 1031 Exchanges only delay taxation on gain and depreciation recapture unless… you hold onto the property until you die. Because assets receive a step-up in basis to current fair market value at death, your heirs can finally sell the property and the tax bill will essentially vanish (unless they hold onto it and let more gain accrue.)
If it otherwise makes sense to exchange into a new property (including transaction costs), then you can just change properties as you need to over the years as long as you don’t do an out-right sale prior to dying.
Cleared to Rejoin
Selling a rental home can bring opportunity and often a sense of relief. Knowing what to expect on April 15th of the following year can be good heart attack prevention. Action steps you can take now to start planning your sale:
- Make sure you track your basis correctly including proper depreciation, splitting the land from the building, and accounting for all improvements.
- Work with a military savvy Enrolled Agent (EA), CPA, or tax-preparer and talk to them prior to the sale.
- If you own, multiple properties, start planning potential sale dates now to avoid a bigger tax bill after separation/retirement.
- Talk to your tax professional about the potential need for an estimated payment in the quarter that you sell the home. This can help avoid a late/underpayment penalty which is effectively leaving the IRS a tip!
