Primary Home Tax Free Gain - To take or Not is the question

As it so often happens, our threads here digress. As so we were talking about advantages of primary home tax free gain on the Apple thread. I wanted some feedback on the basic scenario and calculations I did below so posting this as a separate thread. Comments / feedback welcome.

The question is: when one is ready to move on from the primary home and has the means to buy another primary home plus maintain a rental, what’s the best approach -
(a) convert primary to rental, or
(b) sell primary to reap tax-free gain and buy similar rental.
For evaluation, let’s consider investment horizon is 10yrs after which rental property will be sold in either case.

Scenario:
Initial Purchase Price = \$500k
Assume 100% appreciation in 2-3 yrs
Tentative Sale Price = \$1M
Purchase Price of equivalent rental = \$1M

Max Tax free gain = \$500k
Tax saved (at 15% long term capital gain) = \$75k
Real Estate Txn cost in selling primary and then buying rental = \$60k (6% closing cost on \$1M)
All gains put as downpayment for rental to keep EMI same
Net Savings = \$15k

Annual Property Tax on Primary = \$5k
Annual Property Tax on Rental = \$10k
Increase in annual property tax = \$5k

So, option (b) puts an extra \$15k in the bank initially but with an extra \$5k in annual property taxes, option (a) turns out to be the winner after 3yrs and continues to be the leader from there on.

Did I miss something in this back-of-the-hand calculation?

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Does CA charge state income tax on profits if you sell?

I think if you plan to use the profits to buy a rental, then you keep the home. You can always move back to it later to get the \$500k exemption or sell with 1031 exchange to avoid taxes.

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In 2-3 years making 100% gain is too aggressive, we can fairly assume 5%-8% appreciation per year and home value doubles in 8 to 10 years.

CA exempts capital gain 500k if it is primary home.

Second, assume anyone in bay area (single or double income) earns 100k yearly. When capital gain is added, they move to 20% + obama’s 3.88% = 23.88% tax on capital gain.

Tax gain is 23.88% + CA 9.3% = 33.18% - almost 1/3rd of capital gain of 500k saved = 500/3=167k

You have selling cost 60k (6%) on 1M. You want to buy a rental with that cost and go for another primary. Net savings is 167k - 60k is 107k

But, think this way. Instead of selling 1M home, if you turn the home as rental, you stand to gain every year 5% (least appreciation for BA) which is 50k. In addition, you freeze property tax at 500k original purchase price which is 500k * 1.25% * (1.02) ^ (years holding from original purchase date).

Since the home is appreciated, take cash out refinance (75% or 80%) when it is 1M and when you are using as primary to lock the fixed mortgage at lowest rate.

Use that money for next primary down payment. You have mortgage finance cost, but save 60 k selling expenses.

Nothing can break this real estate equation other than exponential stock gains.

In short, taking advantage of 500k capital gain exemption is not attractive unless we badly need the money or grow the money faster in other business or stocks.

If someone wants to flip often taking advantage of primary capital gain, it is fine then.

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Flip your own home…best tax free business there is… \$500k tax free every other year…Get your own RE license and save 2.5% per flip…

Flip it, sell it, I will tell you how to use the capital gains without using 1031. Any asset applies, just let me know.

@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

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?

You missed at least 1 consideration (favoring scenario b):

1. You will have a bigger depreciation deduction to offset the rental income in b).

Of course, if you are in the buy and hold forever camp (like me or @manch), then it doesn’t really matter, a) is the way to go.

There is a 1031 exchange where you do not pay any tax on rental property sale.

If you apply that logic, then your conclusion will be different.

By all means Scenario A is better than Scenario B unless the owner needs money right away.

And if the owners need money right away, talk to me.

Good point, totally ignored depreciation. Since this is all armchair analysis for me, can someone confirm following info from google is correct?

Technically, you are not required to claim it. But you are required to “recapture” depreciation allowed or allowable when you sell the property, in the future. That is, you will pay tax on the depreciation, when you sell, whether or not you actually claim it while you were renting it out.

What vehicles are you using? I’m too lazy to dig up old posts

That is correct, that is why you should always claim the depreciation. I am counting on 2 instruments to avoid recapturing… 1031 and death

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Can you 1031 amongst your children? Say, you sell to your child1, child1 sells his/her to child2 and child2 sell his/her to you. Can?

Another followup question. Will depreciation recapture tax be due if one would sell a house that was
-bought for \$500k
-initially primary for 5 yrs
-then rental for 2 yrs
-depreciation taken in 2yrs = \$20k
-finally sold for \$700k for a gain of 200k

Basically trying to understand what comes first - home owner capital gains exemption or depreciation recapture.

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I am obviously not a tax professional, so anything I typed here is my “guess”. Please free feel to correct me.

I think depreciation recapture is separated from capital gain (and the tax rate is higher at 25%), so 20k will be taxed at 25%. Primarily residence exemption can only shield you from capital gain…

Again, there is a reason to hold forever and live off by cash out refinance…

Even if recapture happens, Your rental becomes wash off.

With current law, you lived two years as primary in the last five years. You can still claim primary home capital gain exception (few of my friends claimed, no issue with IRS so far).

With this discussion, I have come to the same realization

It seems no change was made to capital gains tax exemption. Same exemption limits and same residency requirements are retained!

I heard 5 years out of last 8 years rule instead of 2 years out of last 5 years.

Home Sale Exclusion

OLD: Generally, where a taxpayer owns and uses a home as his principal residence for 2 out of the 5 years prior to its sale, the taxpayer can exclude up to \$250,000 (\$500,000 for a married couple) of profit from the sale.

NEW: The conference agreement retains the current law.

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