@Jil - Thanks for the corrections. Very useful. I have updated the scenario based on your feedback.
Question:
When a married couple is ready to move on from the primary home (CA property) and have the means to buy another primary home plus maintain a rental (CA property), what’s the best approach -
(a) convert primary to rental, or
(b) sell primary to reap tax-free gain and buy equivalent rental
Assumptions for this analysis:
- All txns happen in CA (BA area)
- Annual income = 200k-250k (BA standard)
- Initial Purchase Price in 2011 = $500k
- Current loan balance on old primary = $350k
- 100% appreciation in 6 yrs from 2011 to 2017
- Since a new primary is being bought in both scenarios so there is no impact of sale price, down payment and RE txn cost for the new primary on this analysis.
- Enough cash reserves exist for downpayment for new primary purchase without needing gains from sale of existing primary
- Rental property will eventually be liquidated in 10-30yrs timeframe
- BA RE appreciation is available in both scenarios since rental property of $1M exists in both scenarios
- Owners are married couple
Scenario A: Convert old Primary to rental and never use $500k tax free capital gain
Loan refi’ed at 3.75% fixed for 30 yr term right before converting to rental
Loan outstanding = $350k
Monthly EMI = $1621k
Scenario B: Sell old Primary and buy rental of equivalent value to get $500k tax free capital gain
2017 Sale Price of old primary = $1M
Purchase Price of rental in 2017= $1M
Max Fed + CA Tax free gain = $500k
Fed Tax saved (at 20% long term capital gain + 3.88% ) = $119.4k
CA Tax saved (at 9.3% long term capital gain) = $46.5k
Total Tax Saved = $166k
Real Estate Txn cost in selling primary (6% of sale price) = $60k
Real Estate Txn cost in buying rental (assume any escrow closing cost offset by buyer agent credit) = $0
Total RE Txn Cost = $60k
Total Savings = $166k - $60k = $106k
Annual Property Tax on Primary = $5k
Annual Property Tax on Rental = $10k
Increase in annual property tax = $5k
Net proceed from sale of primary = $1M (sale price) - $350k (loan balance) - $60k (closing cost) = $590k
Net proceeds deployed as downpayment for rental purchase
Starting Loan balance on new rental= $1M (purchase price) - $590k = $410k
Additional interest cost due to (i) 1/8th point higher rate on rental property and (ii) $60k additional loan = ~$3k per year on a 30yr term
Additional annual spend = $8k
Number of years for savings from scenario B to be wiped out by scenario A = 106/8 = 14.5
Conclusion: If new rental property is liquidated anytime before 15yrs then not taking tax free capital gain was a mistake.
**Thumbrule: While moving to a new primary property, if you have the means to maintain a rental, then decision on whether to harvest tax-free gains depends on anticipated rental property investment time horizon. If investment period is 10yrs or less then harvest tax-free gains. If investment period is 20yrs or more then hold on to low property taxes and ignore tax-free gains.**
What did I miss?