house for sale

House trap?

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I had a slew of clients sell their homes this past year. Probably because the market rebounded and they thought they would finally come out ahead.

The problem? Some of these folks sold their second homes- the ones they rented out for a few years. And, only a few of them consulted with me about their plans. (How many times do I have to explain to folks that PLANning occurs BEFORE the action. There’s not much one can do for a situation that has already occurred. Especially after the year is officially over.)

house for sale

When you sell a residence, you can protect $ 250K (if you are single) or $ 500K (if you are married) of capital gains. Except. Those gains can only be protected if you LIVED in the house for at least TWO of the last FIVE years. (This is called the Primary Residence Exclusion.) If you’ve rented the home for more than 3 years, it’s pretty clear you will be taxed on the capital gains.

(Some of my ‘smarter’ clients did consult with me- and we made plans to cover their gains.  Some executed Section 1031 [like-kind exchanges]; others made the home their residence for this year, so they can meet the 2 of 5 year rule.]

And, there’s more. Because if you rent out (part or all of) your home, you are required to depreciate the value of the home. That’s the law. The fact that you didn’t? Too bad. The IRS considers that your stupidity. (OK. There are some ways around that, but I want to keep this blog to under 1000 words- and less abstruse.)

What that means is that the basis in your house- the one you bought for $ 350K and sold for $ 850K (after the expenses of sale were deducted)- has shifted. Assuming you used that house for 2 years of 5 as your primary residence, you (without consulting me) were giddy that you can shelter all your gains. Nope. You can’t.

Capital gains on house sale

Because you rented the home for 3 years, there were three years of depreciation. And, with about $ 150k of land value, your $ 200K building had been depreciated to the tune of $ 15, 384. So, the basis of the residence is $ 350K – $15384 or $ 334616. So, your gain is larger. And, taxable.

Had you not lived in the house for two years, then that gain is not only fully taxable, but is subject to recapture considerations. Which makes that sale a pretty pricy tax item. Of course, you are sitting on a pile of cash. Which attenuates the tax bite somewhat.

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7 thoughts on “House trap?”

  1. I do keep the house in Wisconsin with family staying in it to maintain it while I am in Mexico, which is pretty much most of the time. I might need to return to Wisconsin for a while before selling. At this point I’m not planning to sell because I want my daughter to enjoy raising her family where she grew up…but who knows what tomorrow will bring. And it has nowhere near the value that you are talking about…it is after all Wisconsin.
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  2. I don’t have a second house – never will. But we had enough fun (with our tax person) due to my mother in law’s house sale. It had appreciated so much and..well, let’s just say I’d rather have fun in other ways.

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