Capital Gain Tax on investment property

[tiyakhambadkone]

We bought a property (let's call it as property A) in Chicago as our primary residence in 2017. We stayed there for 1 year and because of some reasons we moved to another city in Illinois and rented this property.

Now we are selling our rental property. 

Few questions regarding the capital gain tax: 

1.  How should we calculate our capital gain tax. What will be the amount? We bought property for 470K and selling it for 515K. We have not filed for any depreciation deduction in our tax returns till date. We are married and filing jointly. 

2.  11 months back we bought a home for ourselves(let's call it as property B) as our new primary residence. We have a mortgage on this property. Will property B be considered for 1031 exchange for property A? 

3. If we sell both properties A and B and suppose we have capital gain tax on both, then can that money be combined together and applied for 1031 exchange to  buy a single property which will be our primary residence? (this may sound crazy but unfortunately, we may have to move again).

4. Is there any way we can save capital gain tax? 

[tagteam]

You will not be able to use Section 1031 for this transaction because that section allows deferral of gain only when property used in a trade or business (or for investment) is exchanged for other property used in a trade or business (or for investment). Section 1031 simply does not apply to property held for personal use.

In this instance, your replacement property was clearly purchased for use as a primary residence and not for investment or business use. There are also time constraints on the identification of the replacement property and the completion of the exchange as well as constraints on how the exchange must be handled with respect to receipt and disbursement of funds.

See https://www.law.cornell.edu/uscode/text/26/1031 and

https://www.irs.gov/pub/irs-news/fs-08-18.pdf

If your move (from property A) was work-related and/or meets other requirements or exceptions, you may be able to exclude some of the gain (a partial exclusion) from that sale (see the note below the link, however).

See Publication 523 (2020), Selling Your Home | Internal Revenue Service (irs.gov)

With respect to renting property A, you were required to take depreciation deductions each year on that property. If you filed returns for 2018 and 2019 without taking depreciation deductions, then you adopted an impermissible method of accounting which can only be rectified by filing Form 3115.

See https://www.irs.gov/publications/p946#en_US_2020_publink1000107386

Professional guidance would be required in this scenario.

[Carl]

1. How should we calculate our capital gain tax. What will be the amount? We bought property for 470K and selling it for 515K. We have not filed for any depreciation deduction in our tax returns till date. We are married and filing jointly.

Actually, *you* don't calculate that when using TurboTax. The program does those calculations for you, based on the data you input to the program. So if you input the correct data, you'll get the correct values. Basically, your taxable gain will be what you sold the property for, minus what you paid for it. You'll also be able to deduct a few other things from the taxable gain, such as your selling costs which includes any realtor commissions you may pay.

2. 11 months back we bought a home for ourselves(let's call it as property B) as our new primary residence. We have a mortgage on this property. Will property B be considered for 1031 exchange for property A?

Understand that a 1031 exchange is not "considered". It's a type of transaction that is planned in advance and per federal law must be handled by a disinterested 3rd party that is properly qualified and/or licensed (if required) to handle that type of transaction. Since it's apparent by your choice of words that you did not do any kind of 1031 exchange, you can basically drop that line of thought. Besides, 1031 exchanges involve "like kind" property. Since you sold a business property (which is basically what rental property is) and purchased a non-business property (property B - new primary residence) the two properties are not like kind. So there's no way this was a 1031 exchange.

3. If we sell both properties A and B and suppose we have capital gain tax on both, then can that money be combined together and applied for 1031 exchange to buy a single property which will be our primary residence? (this may sound crazy but unfortunately, we may have to move again).

The above makes it more apparent that you just don't know what a 1031 exchange is. But that's okay. It's not like you learn this stuff through osmosis. I'm not going to address this question, because by now I'm sure you're well aware that mixing two properties together that are not "like kind" is not permissible with a single 1031 exchange.

4. Is there any way we can save capital gain tax?

Basically, no. Since property A was not your primary residence for at least 2 of the last 5 years you owned it, the sale of Property A does not qualify for the capital gains tax exclusion per IRS Publication 523 at https://www.irs.gov/pub/irs-pdf/p523.pdf since you don't meet the eligibility test which starts at the bottom of page 2 of that document.  I'm also fairly certain that you don't qualify for even a partial exclusion since you make no mention of moving from Property A because of a change in workplace location, a health issue, or an unforeseeable event. (page 6 of publication 523)

[Critter-3]

Since you did NOT depreciate the property as required  you must recapture the depreciation even if you did not take  it .... to avoid this double taxation you must use a local tax pro who is familiar with form 3115.  This fix is not a DIY process.  

[Hal_Al]

You may exclude the capital gain ($500K limit for married) on the sale of your primary residence (property A) if you owned and lived in the home for 2 out of the 5 years prior to the sale.  If you lived in it less than 2 years but moved (at least 50 miles) for employment reasons*, you may still exclude the gain.  The $500K max is reduced (in your case [lived there 1 year] to $250K).  Since your gain was only $45K, you get to exclude it all.  But, you must pay tax, at ordinary income (not capital gains) rate, on the depreciation you shoulda claimed while renting it out. You have one additional criteria to meet: you must sell within 3 years of moving out. So, for example if you moved out Sep 30, 2018, you must sell by Sep 29, 2021. 

You may only claim the capital gain sale exclusion every two years.   So, if you sell property A (and exclude the gain) in 2021, you cannot exclude the gain on the sale  of property B, unless you wait two years to sell it.

*There are other "unforeseen circumstances" that may qualify you for an exception.  See 

http://www.nolo.com/legal-encyclopedia/the-partial-home-sale-tax-exclusion-irs-approved-unforeseen-c...

[Hal_Al]

Previous reply edited.  

Based on court decisions no partial exclusion for selling for health, change of employment or unforeseen circumstances would be available if the sale is more than 3 years from the time you moved out.

[tiyakhambadkone]

@Hal_Al  you mentioned "If you lived in it less than 2 years but moved (at least 50 miles) for employment reasons*, you may still exclude the gain.  The $500K max is reduced (in your case [lived there 1 year] to $250K).  Since your gain was only $45K, you get to exclude it all. "

I am not sure if this applies to us. We bought the property in July 2017. We lived there for 1 year and rented in August 2018.

The reason we moved was - when we bought the property I had no job. After we bought the property, I got a job around 20 miles away from the property. I was pregnant and had a difficult pregnancy and was driving everyday on the interstate with heavy Chicago traffic. It would take at least 1.5 hours one-way during peak hours and was difficult for me. Also, once the baby was born I didn't want to leave the baby at a daycare near home and drive 1.5 hrs away from a 3 month old baby because if anything is needed urgently I won't be near to be there. Baby was born in July 2018.
So looking at all these things, we made a hard decision of renting our property and moving out. 
I don't know if this reason qualifies for the exclusion reasons. 

We have been renting out the property from August 2018 to July 2021 and selling in July 2021. 

We have been paying the rental income tax but did not claim any depreciation deduction.

So can you tell me if this partial exclusion rule would apply to us? We spoke to 1 CPA and she just told us about the 2yrs and $500K rule. 

[Hal_Al]

Q.  So can you tell me if this partial exclusion rule would apply to us?

A.  Yes,  Probably.  You may have a hard time getting somebody to give a firm answer to that question.  Qualifying for the "unforeseen circumstances" exception to the 2 year rule depends on the details.  I'd go for it. 

"Life events the service [IRS] has most frequently ruled upon are those taxpayers did not plan when they purchased a residence and that increased the number of dependents living under one roof. They include the addition of children via pregnancy" Reference: https://www.journalofaccountancy.com/issues/2009/nov/20091783.html

The other reference cited above is repeated here: http://www.nolo.com/legal-encyclopedia/the-partial-home-sale-tax-exclusion-irs-approved-unforeseen-c...

[tagteam]

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@tiyakhambadkone wrote:

We have been paying the rental income tax but did not claim any depreciation deduction.

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That is an overarching issue in your scenario.

You need to address this prior to the exclusion since depreciation recapture cannot be excluded under Section 121.

[gerhardplenert]

My situation is a little different - I purchased a piece of land less than one year ago and now I want to sell it but I understand that if I keep the property for at least one year I'll have a lower tax rate ---- is that true???

[VolvoGirl]

Yes the profit will be taxed at lower long term capital gains rates instead of ordinary income for short term.

[Hal_Al]

That's true. It then becomes a long term capital gain, which is taxed at a lower rate that "ordinary income" and short term capital gains (property held/owned less than 1 year ).