High Value Family Home?

Thinking ahead to the day when you will sell your primary residence? If you feel stalled because of the gains tax you may owe for the amount exceeding the tax exclusion, check out this idea.
The problem of gains exceeding the $250K or $500K thresholds allowed by the IRS affects typically challenges older, not younger homeowners. Younger homeowners rolling over home equity into another home purchase may clear little if any equity subject to taxation. Federal and state taxes on the capital gain in excess of these exclusions for single or married taxpayers would therefore not kick in.
But midlife or older people headed into retirement may have a tougher time protecting this equity from the taxman when they sell to downsize. Or to relocate to a less costly area.
One workaround for the section 121 cap on exclusions from gain tax would be to partly or to fully convert a primary residence to a rental property. This conversion can be made by renting rooms, a portion of the house, or a garage for residential or commercial use. The higher value the home, the better, if the objective is to clear more equity for potential tax free rollover. The rented portion of the home can be considered by the IRS as now an investment property, subject to a different set of rules for capital gains taxation. The rental conversion must be done for at least 2 years and the income separately reported in tax filings for that period.
People who rent out the entire home need to be clear on how much if any they will claim of a mortgage interest deduction for a primary residence. Consult with a tax professional before making this decision. It may be better to take the interest deduction as an expense of ownership of the rental property, along with other expenses.
If the homeowner wants to rollover a gain upon sale of the residence after renting out the home, he or she can still claim the primary residence exclusion from gains tax assuming he or she has lived in the home for 2 out of 5 years. In the case of a mixed use residence, the square footage percentage corresponding to the rental would need to be computed in determining how much of the proceeds would be handled in like kind exchange to another rental property. A defined, specific set of rules applies, to qualify.

Recently, I moderated a panel discussion on the subject of rental real estate and opportunities this path may offer for retirement income. Not only do rentals provide direct income, they can provide income necessary to augment retirement savings over time if the rents are directed into other investments.

In areas where property values are high, many people have much of their net worth invested into their homes, rather than retirement portfolios. Many of these boomer age retirees are seeking ways around what can be a big tax bite into sale proceeds that could otherwise help finance retirement.

Like any investment, rental real estate can rise and fall in value. Of course, the income it provides depends on the ability of tenants to continue paying. However rentals differ from securities investments in that real estate may be leveraged, that is, subject to a mortgage. That is, people may investment just part of the necessary capital to buy a home, rental, or multi unit property; the remainder of the purchase is invested by a bank subject to loan terms.
If the property value falls below the amount of equity invested, the buyer may experience negative equity. That is, he or she could only sell by taking a loss. However people who carry a mortgage on the properties are therefore able to deduct the cost of the mortgage against their passive income from tenant rents. Making money on rental property is, in my view, an exercise in running a small business.

Just as most people would build a spreadsheet to analyze the risks and possible returns for a business venture, the investor in rental property should apply the same discipline in determining breakeven and profitability, as well as long term yield from the rents, before entering into a transaction. Real estate cycles should also be considered, to allow for normal market appreciation and declines. A consultation with a tax expert, as well as with an informed realtor, is time well spent. A real estate attorney can help bridge the pitfalls of like kind exchanges.

CPA Alexia Cloutier said it would “advisable to run the numbers with your CPA on the proposed rental income and expenses.
“Plan for quarterly estimated tax payments as needed,” she said. “Remember you also need to include depreciation expense which can lower your net taxable rental income. However upon selling the property you must reduce your cost basis by the amount of depreciation expenses that you previously took on your income tax returns. This may increase your taxable capital gains upon sale.”

When it comes to estate planning, there may also be advantages to rental property in reducing costs to an estate. “If the property is left to a spouse or child,” Cloutier said, ”there may be a step up in basis upon death that could reduce the taxable capital gain on the sale of the property.

“This can be complicated and you should discuss your specifics with your CPA. For example, property held in a marital trust will get a step up in basis, but a bypass trust does not get a step up in basis, ” Cloutier said.

Late bloomer newlyweds ”to be” may also find the conversion of a primary residence to a rental property useful when choosing between homes to sell. Renting one and living in the other can preserve more capital for financing the years ahead.

Kathleen Nemetz, MBA, CFP®, CDFA™
McClurg Capital Corporation
415.472.1445
www.life-as-planned.com