Being a landlord can be taxing – literally! So what do you do, and what are your options if you want to sell your investment property?
Your Financial Plan
Whatever the reason for selling, the first and most important step is outlining a financial plan. Meet with your tax adviser to get the ball rolling and determine what you want to do with the proceeds of the sale. No investor should ever sell a property without a full understanding of the financial impact. If the property is a multi-family unit, make sure the rental income is bringing in market rate for the neighborhood. This income helps determine the value of the property.
Many investors take advantage of the current tax laws and use the 1031 exchange to upgrade their real estate portfolio. If you sell your investment property and want to roll it into a new real estate investment, have the investment you want to buy ready when you’re set to sell. You’ll need to move the earned money into that property within 180 days or you’ll have to pay capital gains tax.
Convert from Investment Property to Principal Residence
Most homeowners understand that under Section 121 of the IRS Code,
A taxpayer may exclude gains realized on the sale or exchange of property if the property was owned and used as the taxpayer’s principal residence for at least two years during the five-year period ending on the date of the sale or exchange. Section 121(b) provides generally that the amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns).*
Before, real estate investors could trade into a property with a 1031 exchange, rent the home for a while and then move into it and exclude all or some of the gain under Section 121.
However, the code was recently amended to:
If a taxpayer acquired property in an exchange to which § 1031 applied, the § 121 exclusion will not apply if the sale or exchange of the property occurs during the five-year period beginning on the date of the acquisition of the property. This provision is effective for sales or exchanges after October 22, 2004. *
Then, the amount of the gain that the investor can exclude is reduced to the extent that the house was used for something other than a primary residence. This exclusion is reduced pro rata by comparing the number of year the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.*
Hypothetically, a married couple purchases an investment property with a Section 1031 exchange. They rent the home for three years and then convert the home to their principal residence. At the end of six years, they decide to sell, netting a total gain of $900,000. Under normal circumstances, section 121 allows them to exclude $500,000, however, since they acquired the property through a 1031 exchange and they owned the property for a minimum of five years, they’re only able to exclude some of the gain.
They rented it for three of the six years, or 50 percent of the gain, or $450,000 isn’t excluded. Because of this new limitation, the couple is only able to exclude $450,000 rather than the full $500,000 gain. There are many intricacies and exceptions, and anything involving a 1031 exchange should be discussed in detail with your tax adviser and CPA.