Taxation on the Sale of Your Home with a Focus on Depreciation – Part 2

 

Jane Young, CFP, EA

When you sell a home that has been rented there are restrictions on your ability to exclude all of your gains.  As mentioned in last week’s article, you may be able to exclude up to $250,000 in gains if you are single and up to $500,000 if married filing jointly, assuming you have lived in your home for 2 of the past 5 years.  However, after January 1, 2009, this exclusion is limited to the gain associated with the time your home was used as a primary residence.  You cannot exclude any gain that may be attributable to depreciation allowed after May 6, 1997.

When you rent your home, the IRS allows you to take a depreciation deduction. This enables you to spread the cost of your property over time and temporarily shelter some of your income from taxes.  Residential homes are usually depreciated over 27.5 years using the fair market value (FMV) of the property at the time you began renting the property.  Only the building can be depreciated so you need to subtract the value of land from your FMV before calculating depreciation.

Depreciation can be a great way to shelter taxes, at least while you are renting your home.  However, when the property is sold you cannot exclude any gain equal to the depreciation allowed or taken, even if you lived in the home for 2 of the last 5 years.  The IRS refers to this as unrecaptured Section 1250 gain or depreciation recapture and this is taxed at a maximum rate of 25% instead of capital gains rates.  You may be tempted to forego taking the depreciation deduction to avoid the 25% depreciation recapture.  However, this is not a good idea because the IRS calculates recapture on allowable depreciation not depreciation actually taken.

If you have a loss on the sale of your home you may be able to escape recapture of depreciation. When calculating the gain or loss on the sale of your home, depreciation is deducted from your adjusted basis.  If you still have a loss after deducting depreciation you will have no gain from which you need to recapture depreciation.

On the other hand, if you anticipate a substantial gain and think it may be advantageous to postpone a large tax hit, consider a 1031 exchange also known as a like-kind exchange.  The IRS rules regarding 1031 exchanges are very stringent and can be quite complex.  If you are considering a 1031 exchange it’s advisable to work with a tax professional that specializes in this area.

 

Taxation on the Sale of Your Home – Part 1

Jane Young, CFP, EA

In most situations, if you sell your personal residence that you have lived in for 2 of the last 5 years, you will qualify for an IRC Section 121 Exclusion.   Section 121 excludes gains of up to $250,000 for an individual and $500,000 for a married couple filing jointly.  You must own your home and use it as your primary residence.  Married taxpayers may exclude up to $500,000 if either spouse owned the home for 2 of the last 5 years and both spouses lived in the home for 2 of the last 5 years.   If eligible, you can use this exclusion once every two years.  Any gains in excess of the exclusion will be taxed at capital gains rates.  If your gain does not exceed the exclusion you don’t need to report the sale on your tax return.

If you own more than one home, you are only eligible for the exclusion on your primary residence.  Additionally, you are not eligible for the section 121 exclusion if you acquired your home through a like kind exchange (1031 exchange) in the last 5 years or if you claimed an exclusion over the past 2 years.  If you don’t meet the requirements because you lived in your home for less than two years and the reason for the sale is due to poor health, change of employment, death, divorce, or other unforeseen circumstances, you may be eligible for a partial exclusion.  Additionally, special rules apply to qualifying members of the Uniformed Services or the Foreign Service and employees of the intelligence community and the Peace Corps.  The exclusion of gains does not apply to gains attributable to depreciation claimed for rental or business use after May 6, 1997.
If you lived in your home for 2 of the last 5 years but failed to use the home as your primary residence at any time after January 1, 2009, some of your gain may be ineligible for exclusion.   The time during which your home was used as a rental or vacation home is considered non-qualified use.  Any gain on your home during this timeframe is not eligible for exclusion and will be taxed at capital gains rates.  This does not reduce the actual amount of your exclusion and if your gain is large enough you may be able to use your full exclusion.

To calculate the gains attributable to non-qualified use, divide the number of years of non-qualified use (years home not used as primary residence after 2008) by the total number of years the home has been owned.  For example if you rented your home for 4 years and owned your home for 20 years, gains attributed to non-qualified use are equal to 4/20ths or 20%.  Therefore, 20% of the gain will be taxable (plus any depreciation recapture) and 80% may qualify for exclusion.

Depreciation will be addressed in Part 2 of this article.

More to Rental Property Than Meets the Eye

 

Jane Young, CFP, EA

Jane Young, CFP, EA

With low interest rates and the fear of another drop in the stock market, many people are looking for alternative ways to earn investment income.  Many investors find the tangible nature of real estate appealing.  Although real estate may seem like the logical alternative to stocks and bonds, investment in real estate can be very complex, time consuming, and wrought with risk. 

Before buying, perform a realistic cash flow analysis on the income and expenses associated with the property you are considering.  Begin with start-up expenses associated with acquiring the property, including the down payment and any necessary improvements. Next tabulate the routine expenses that you will incur with a rental.  These may include mortgage payments, insurance, property taxes, home owner’s association dues, routine maintenance, and legal and accounting fees.  As a rule of thumb, maintenance and repairs run about 1-2% of the market value of your home, depending on the home’s condition.  Also consider an emergency fund to cover large unexpected repairs. 

Managing rental real estate can be very time consuming.  Seriously think about whether you want to manage the rental yourself or you want to hire a property manager.  Do you have the time and the desire to manage the property? If you do it yourself, you will need to market the property, evaluate potential renters, maintain the property, respond to tenant issues, collect rent payments and potentially evict tenants.   You also may want to learn about fair housing laws, code requirements, lease agreements, escrow requirements, and eviction procedures.  If you don’t have the time or the temperament to manage the property, consider hiring a property manager.  Property management fees usually run about 10-12% of rental income.

Some additional risks to consider when renting property include the possibility of major damage inflicted by a tenant, drawn out eviction processes, and law suits for negligence and safety issues.

After evaluating your expenses, do some income projections.  Research rents paid for similar properties in your target neighborhood.   Be sure to incorporate a reasonable vacancy rate.  According to the Colorado Division of Housing, the average vacancy rate in Colorado Springs has been about 6%, for the last 4 quarters.

Include the tax benefit of deducting depreciation into your analysis.  To calculate annual depreciation, divide the initial value of your rental home, not including land, by 27.5.  Unfortunately, you will probably have to recapture (repay to the IRS) this deduction upon sale of the property at a maximum rate of 25%.

Subtract your projected expenses from your projected income to determine your net profit.  Will the net profit you expect to gain from the property compensate you for your capital, time and risk?  In addition to the profit from rental income, be sure to factor appreciation of your property into your analysis.  Additionally, if you have a mortgage, your equity will increase every year as you pay off your mortgage.

Selling Home May be Better Option Than Renting

 

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Jane M. Young CFP, EA

 

It’s time to move but you hate to sell your house when the market is down.  Maybe you should rent your house for a few years? Or, on second thought, maybe not.

There are many factors to consider before deciding to rent your home.  Do you have the temperament and the time to be a landlord?  Are you comfortable with the idea of having someone else living in your home?  Do you want to manage the rental yourself or do you plan to hire a property manager?  If you manage the property yourself do you have time to learn about fair housing laws, code requirements, lease agreements, escrow requirements and eviction procedures?  Who will take care of repairs and maintenance and are you ready for tenant calls in the middle of the night?  If this sounds a bit daunting, a property manager may be your best option.  A property manager will cost you about 10% of the rent.  Be sure to include this in your cash flow analysis.

Before renting your home do a realistic cash flow analysis.   Add up your projected expenses and deduct them from your projected rental income to see if renting will result in a profit or a loss.  If you project a loss, does your projected appreciation on the home while it’s rented compensate you for the time and money it will cost you? Do you have funds to cover a negative cash flow?  Your expenses may include your mortgage payment, property taxes, insurance, home owner’s association dues, maintenance and repairs, legal and accounting fees and property management fees.  A rule of thumb for maintenance and repairs is about 1 – 2% of the market value of your home, depending on the home’s condition.   You may need to spend money up front to attract good quality tenants.

When calculating your rental income, you need to decrease your projected rental income by about 8% to allow for vacancies.  In Colorado the average rental vacancy rate has been around 7-9 percent over the last five years, based on U.S. Census data.  When a renter moves or is evicted it can take several months to get a new renter in place.

If you rent you can take a tax deduction for depreciation against your rental income.  To calculate your annual depreciation, take the value of your home, on the date you begin renting, less the value of land and divide it by 27.5.  Unfortunately, this is just a temporary gift from the IRS.  When your home is sold you must recapture all of the depreciation at 25%.

Other potential drawbacks to renting your home include the possibility of major damage inflicted by a tenant, drawn out eviction processes, negligence or safety lawsuits and costly maintenance issues.

An additional consideration, if you have a capital gain on your home, is the loss of the capital gain exemption of $250,000 for individuals and $500,000 for a couple if you haven’t lived in your home for 2 or the last 5 years.