Cool Things to Lower or Defer Taxes on Rental Properties and Section 1031 Exchanges

***I am not a tax expert.  Below is a discussion on the sale of rental properties, mixed use properties, and tax considerations.  I don’t know your situation.  Consult a qualified tax expert for further information applicable to you.***

I was a landlord for 7 years.  It was both good and bad, enjoyable and annoying.  I liked receiving the monthly cash flows, but sometimes couldn’t wait for the lease contract to be over.

One thing you can’t deny about being a landlord is the fact that there are a lot of deductions you can take on a rental property.  You can depreciate the structure (not the land) over 27.5 years which saves a lot in taxes on the rental income, paint, repairs, mileage, just a few others to mention (KEEP GOOD RECORDS).

However, just like in physics, every action has an equal an opposite reaction.  Or maybe, just maybe, there is an exception to this rule.

What am I referring to?  Let’s say you’re a landlord.  You rent out the property for a number of years and later on decide you wish to stop being a landlord.  Maybe you got tired of the renters, or location, location, location benefits you and the property appreciates significantly in value.  The reason doesn’t matter.  What matters is you sell the property and will run into a huge tax bill.  All the years you rented the property, you benefit from write offs and that depreciation.  You probably thought, sweet that depreciation is really saving my butt from paying a bunch of taxes on the profits (taxed as ordinary income), really depreciation is just deferring some of the taxes.  When you get ready to sell the property, something you need to be aware of when selling a rental property: you pay taxes on the gain of the sale of the home and also on the depreciation taken for all of those years (this is why good records are important).  That’s physics for you, the action followed by an equal and opposite reaction.  It’s a bitch ain’t it.

Hope is not lost though.  I’m all about making money, but also keeping as much of my money as possible (legally).

So what’s a landlord to do?  Here are a few options to soften the blow on the taxes.

Move in and make the rental property your Primary Residence

When you decide to no longer be a landlord, you can sell your existing primary residence and move into the rental property (thereby making it your new primary residence).  Since you won’t be selling your rental property, there are no taxes due until you ultimately dispose of the property.  Keep records of when you moved into the rental property and how long you’ve owned it, also all the years of depreciation that you took as a landlord.

What about taxes on the sale of your initial primary residence?  Well, the IRS has a pretty friendly benefit to homeowners on the sale of their primary residence.  When you live in that home for 2 out of 5 years, you can sell the residence and gains on the sale up to $250,000/$500,000 (single/married and a lifetime limit) are TAX FREE.  So, if you are not bumping up against those generous limits, you can sell your primary residence, move into the rental property and establish the rental as your new primary residence.

This allows you to unlock the equity from your old home, and you already have another place to live (the former rental property).

A few things to think about.  You have to time things right, but it’s easier than timing the stock market.  You basically wait for the lease to end or get close to ending with your renter and make sure to give them notice about not renewing their lease and keep a record.  Get your primary residence ready for sale in the meantime.  Ideally your renter moves out and your home sells shortly after.  Again, if you are not bumping up against the lifetime limits mentioned above, not taxes owed on the sale of your primary residence; also you did not sell the rental property, so no tax on gains are owed yet.

You probably notice me mentioning no taxes are owed yet on the gain from the sale of your rental.  That’s correct.  Yet.  Eventually, if you decide to sell the property, then there will be taxes on the gain of the sale.

What about the 2 out of 5 years you mentioned?  Well, you should be pissed off at congress for that one.  Prior to January 1, 2009, you would have been able to move into a rental property, make it your primary for 2 out of 5 years and get the tax benefits of a primary residence sale (still owing tax on the depreciation though).  However, a sneaky thing that got little attention and was snuck into a bill back in 2008 (remember first time homebuyers getting those $7500 interest free loans and $8000 credits), congress basically got rid of landlords moving into rentals and taking legal advantage of the 2/5 rule. There’s that physics crap being a bitch.  So, first time homebuyers got a benefit (cheap or free money) at the expense of landlords planning to work the rules in their favor.

Landlords still have a benefit from the home sale exclusion (the 2/5 thing).  It’s just a little different now.

Let’s say you do the above (sell primary/move into your rental property) and eventually sell the “new” primary residence.  What the IRS looks at is the total ownership time of the property.  How much of the time was the property a rental vs your primary residence (also referred to as qualified vs nonqualified use).  Let’s say you owned the property for 5 years.  3 years as a rental and 2 years as a primary residence.  bought the property for $200,000 and later sold for $400,000.  Since this is mixed use (rental/primary) you have $200,000 in gains that needs to be addressed.  Of the $200,000 in gains, 40% (2/5 years) or $80,000 will not be subject to taxes.  The rest, well sorry.  Of course, you could live the place longer, and as your percentage of primary use goes up, the amount of gains subject to taxes goes down.

I did this on my last place and it wasn’t too hard to work out the logistics, since I own a few boxes of things and I am a bachelor.  Actually staying there for 2 years was the harder part because I was ready to retire, but it saved a nice amount from being subject to taxes.

Alternatively, I could have stayed there forever, never worried about paying the taxes, died, and my beneficiaries get the benefit of a step up in cost basis, and ALL taxes magically disappear (including that pesky depreciation).

Section 1031 Exchange

Another option is something called a 1031 exchange.  This is more for someone that wants to stay in their primary residence and not go through the hassle of moving into the rental (yet!).  Section 1031 allows you to sell your rental property and defer the taxes from the sale provided the property is exchanged for a like-kind property.

What does that mean?  You have a rental property, rent it, depreciate it, do your write offs,  all while the property appreciates.  You sell the property, but turn around and plow all of that money into the new rental property.  Wash, rinse, repeat, until you find the last rental property you want to retire in (hello beach front property!).  Basically I’m saying buy rental, sell rental, buy new and nicer rental, sell that rental, buy you dream property to eventually live in.  All while taking depreciation on the rental property.

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A couple hoops to jump through for 1031 exchanges to work.  You have to identify the new rental property within 45 days of the closing of the old property AND close the new property within 180 days.  You also CANNOT  receive the money (this is where the escrow company comes in).

1031 exchanges work to simply defer taxes on the sale of a rental.  However, if you move into that last rental property (that happens to be on the beach) and live there until death, your beneficiary gets the benefit of a step up in cost basis, magically making your taxes disappear all while you got a great tan.  You also need to attempt to rent out that final property for at least 2 years before moving in.  The other sweet thing, you’ve taken depreciation on your rentals all along the ride helping the taxability of your rental income.

Working with a good closing agent at the title company is your best resource for 1031 exchanges.  Just make sure they have experience in the area.

So while I’m not into being a landlord anymore, there are definitely some cool things you can do with respect to lowering and/or deferring taxes on the sale of your rental property.

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Readers Comments (2)

  1. Thanks for writing this. Learning about 1031 exchanges was on my to-do list this year.

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