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Why You Should Rent Out Your Primary Residence Before Selling

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There are two things in life that are certain: death and taxes. And if you’re about to sell a property, then you know what’s coming next: capital gains tax.

In the context of real estate, capital gains taxes are taxes that you owe for profits you make from the sale of a property. Homeowners may be aware of how to use capital gains tax exclusions and 1031 exchanges to their advantage, but there’s a way to save even more by utilizing both.

First things first:

What does Section 121 do?

IRC Section 121 allows $500,000 in capital gains tax exclusions for married homeowners on their primary residence and $250,000 in exclusions for single homeowners, meaning that the first $250,000 or $500,000 in profit that a homeowner makes on their primary residence is exempt from any California or federal tax.

To qualify for this exemption, you must have:
1. Owned the property for at least two years;
2. Used the property as your primary residence for at least two of the past five years;
3. Cannot have used the Section 121 exclusion in the past two years;

This effectively means that you can rent your home for up to three years and still pocket the $250,000 or $500,000 exemption.

For example, if you and your spouse purchased your home for $500,000, meet the aforementioned requirements, and sell it for $1 million, you will not owe any capital gains tax because the gains in this instance amount to $500,000, which is the exempt amount for married homeowners under Section 121.

How does a 1031 exchange work?

If you’re selling in Silicon Valley — where average home prices run in the millions — and looking to keep more profits with the sale of your home, you may still face a hefty capital gains tax, despite the Section 121 exclusion. This is where a 1031 exchange can be used to your advantage.

The 1031 exchange, named after IRC Section 1031, involves an exchange of one investment property for another of equal or higher value. Since an owner is placing any profit received from the sale of one investment property into the purchase of another, the rationale is that the owner does not need to pay capital gains tax because they have not cashed out any of the “gains” made.

There is no limit to how many times an owner can defer their capital gains taxes through this exchange method; the capital gains tax will only be due when the owner eventually sells their investment property for cash.

How can both Section 121 and a 1031 exchange be used to my advantage?

If you rent out a property for a year or more, it may qualify as an investment property eligible for a 1031 exchange. This means that if you have both lived in that property as your primary residence for at least two years and later rented it out, it can qualify as both a primary residence and an investment property. A homeowner can pocket the untaxed $250,000 or $500,000 that you gained from the sales proceeds (via IRC 121), and ‘roll’ the remaining proceeds into an investment property and pay nothing in capital gains.

Let’s say you’re a single individual who purchased a townhome in Cupertino for $500,000 in 2005 that is now worth $1.5 million. If you sell the property immediately after living there as your primary residence, your tax base will be $500,000 and you will be exempt from $250,000 under Section 121. However, you will be responsible for paying capital gains tax on the remaining $750,000. At a 33.3% tax bracket (20% top federal capital gains bracket, 13.3% top CA bracket), you as the seller would have to pay $249,750 to the federal and state government in taxes.

Instead, if you rented your home for at least a year before selling, you can use the
$249,750 that you would have owed in taxes and invest that money into another investment property in any state. Depending on where you’re looking to purchase, that money could be enough to buy a property outright without financing or used toward a down payment on a single-family home or duplex.

What’s the catch?

There are timing considerations to keep in mind when conducting a 1031 exchange and managing a rental property, especially one that is far from where you live and be a lot of work. Additionally, conducting a 1031 exchange means you may still pay capital gains taxes at a later date (although we have strategies for that as well).

That being said, each situation is unique and it’s always best to consult with your CPA/attorney before making any big financial decision. Luckily, the Kei Realty Group is composed of attorneys with tax and real estate backgrounds and we have successfully implemented various strategies for numerous clients in the past. Chances are there are several ways to achieve your real estate and financial goals, so don’t hesitate to reach out if you have any questions. We’re always happy to chat more about your specific needs and questions at 408-472-4127 or by email at hello@keirealty.com.