Sale of a Rental Property in May 2020

[sk4000sk]

Hi..I have been a user of Turbo Tax for now 15+ years and purchased the 2019 Premiere. I live in NC state. I purchased a property in Oct 2007, say for 250K and it became my primary residence. The land value at the time of purchase was, say 25K.  I added renovations to the property, say 30K. In Dec 2016, I purchased another property, which became my primary residence. From the old property I borrowed (HELOC), say $ 125K to put a down payment on the new property. When I closed the new property, I rented out the old property. It was rented all the way till Dec 2019 and now it is vacant. I am either attempting to rent it again or sell the old property.

If I decide to sell the old property, say for 400K, and it closes in May/June 2020, while it is not been rented for whole of 2020, I have the following questions:

1. In 2020, will it be considered an investment property?

2. Will the 2 of the 5 year rule still apply for me to avoid any capital gains tax in the year 2020 without reinvestment of the sale proceeds, since I already bought another house in Dec 2016? Joint ownership 500K

3. If it is considered an investment property and the sale in 2020 will incur capital gains tax, based on the original land value, what will be the approx gains tax amount? How will I calculate inside Turbo Tax in 2020? The property tax value for 2020 is say 350K. Also, if I have taken depreciation for 3 years during rental and deducted rental expenses, will that count into capital gains determination as well?

4. Will Capital Gains apply for both Federal and State? If you can suggest % 

5. Since I will have to pay off Mortgage and HELOC post sale, will that reduce Capital Gains tax?

6. If I reinvest the sale amount within 120 days paying off the mortgage balance and HELOC, will it avoid Capital Gains? Does the new investment has to be another real estate or can it be mutual fund, IRA, stocks, etc.? 

7. Would it be best to continue to rent or sell the property? I was thinking selling and applying the 2 of 5 year rule and avoid Capital Gains.  

Appreciate your reply!!

[jtax]

Hi @sk4000sk. A lot of good questions. I'll give you some info on some of them and leave others for other volunteers to answer.

First off reinvestment of proceeds does not avoid capital gains. (Unless you you do a very special thing called a like-kind (or section 1031) exchange. That requires special advise and very exacting procedures and time lines. https://www.investopedia.com/terms/l/like-kind_exchange.asp )

1. yes it will still be a rental because it was last a rental (Dec 2019), had been a rental for a long time. If you had used it personally in 2020 (say as your residence or storage) or intended to that might be different.

2. The $250k/$500k exclusion is from the tax code section 121.  https://www.law.cornell.edu/uscode/text/26/121 It does not seem to apply to you because you can't meet the personal residence for 2 of the last 5 years (see below and review very carefully because you are close.)

• You can't exclude gain due to depreciation reducing your basis. See 121(d)(6).
• Be sure to check the dates very carefully.  You are getting close the 5 year and 2 year periods. It seems like it might not apply but it is close. It may depend upon when in 2020 you sell. If you sell 6/30/20, then 5 years before is 7/1/15. Using round dates (e.g. 12/31) you would have lived in it 7/1/15-12/31/16 (1.5 yrs) and rented it from 1/1/17 to 6/30/20. (3.5 yrs).  So you don't seem to meet the 2 year requirement.
• Your exclusion ($250k/$500k) is reduced by the portion of time it was not used as a residence. Search for "example" in http://www.exeter1031.com/article_changes_to_section_121.aspx keep in mind that article is from 2008 and may not be fully accurate anymore.

3. Capital gains is not based on the land value. It is based on your gross proceeds (minus cost of sale, e.g. commissions, transfer taxes) of the sale minus your adjusted basis. Your adjusted basis is the cost you paid for the property (land, building, roads, sewer, whatever) plus improvements minus depreciation.  Note that loans have nothing to with gain calculation. 

TT will walk you through the sale. If you have used TT for the rentals it will automatically know the depreciation numbers and will deal with any recapture correctly.

Capital gains rates are super low. Typically they are 15%. Can be 20% if you make more than about $400k (single, $488 joint). There can even be a small amount taxed at zero if you don't have much income. (Not likely if you have a significant gain. See https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/

(And if you don't like paying gain on the depreciation just remember that you deducted it from ordinary income taxed at a higher rate and had the use of that money tax-deferred for years. A very good deal for you.)

4. It appears that NC has a 5.5% capital gains tax rate. https://pocketsense.com/capital-tax-laws-north-carolina-8497762.html

5. No. You only pay tax on the gain not the proceeds. Loans do not enter into the gain calculation.

6. Where did you get the 120 days? You can't avoid capital gains by reinvesting unless you do a 1031 exchange. (Pre 1997 I think you could reinvest your primary residence proceeds and defer taxes, but not since then.) I think the 1031 exchange deadline is 180 days with the replacement property (must be a like kind, here a rental real estate property) identified within 45 days of sale. If you do this you must get professional advice.

7. That is too hard a question for a volunteer forum and one for which there is likely no answer.  A lot of that depends upon the rental income compared to your equity, how much you think it will increase, how much you think the property will appreciate and what your alternative investments are. Simply not possible for us to know those things. You might seek the advice of a certified financial advisor (look for the CFP designation) who works with rental real estate and pay by the hour not by commission on investment products sold.

I hope that helps a little bit. Please triple check the 2 of 5 year dates and continue to research that. This is my initial thoughts on that but you should be certain either way.

[Carl]

1. In 2020, will it be considered an investment property?

Yes, provided you do not live in it for one single day after the last renter moved out, as your primary residence, 2nd home, vacation home or any other "personal pleasure" use.  You will *NOT* convert the property to personal use and you *WILL* report the sale in the SCH E section of the program. Just because it may not be rented for a single day in 2020 does *NOT* change the fact that it remains classified as residential rental real estate in 2020.

2. Will the 2 of the 5 year rule still apply for me to avoid any capital gains tax in the year 2020 without reinvestment of the sale proceeds, since I already bought another house in Dec 2016? Joint ownership 500K

When you sell *ANY* real estate property, it *does* *not* *matter* what you do with the proceeds. It has absolutely no effect what-so-ever in any way, shape, form or fashion on the potential taxability of any gain you may realize on the sale.  If you qualify for the "2 of last 5" exclusion, you qualify. Basically, the home must have been your *primary* residence for at least 24 of the last 60 months you owned it, counting backwards from the closing date of the sale.

3. If it is considered an investment property and the sale in 2020 will incur capital gains tax, based on the original land value, what will be the approx gains tax amount? How will I calculate inside Turbo Tax in 2020? The property tax value for 2020 is say 350K. Also, if I have taken depreciation for 3 years during rental and deducted rental expenses, will that count into capital gains determination as well?

When you first started renting the property out, it's depreciation value is the *LESSER* of what you paid for it, or it's FMV on the date of conversion from personal use to residential rental real estate.

Property improvements done *before* the conversion to rental property can be included in the main property entry in the assets/depreciation section. Property improvements done after converting it to a rental are entered as a separate asset in the assets/depreciation section and depreciation on that specific assets starts on the date that specific asset was placed "in service". You are required by federal law to depreciate rental property.

In the year you sell the property all prior depreciation is recaptured and taxed. Recaptured depreciation is *not* exempt from being taxed under the "2 of last 5" rule. Bottom line is you *WILL* pay taxes on recaptured depreciation *no* *matter* *what*. Additionally, be aware that recaptured depreciation is added to your AGI and that has the potential to put you in the tax higher tax bracket. But with only 3 years of depreciation I wouldn't worry about it.

So in the end, if you qualify for the capital gains tax exclusion under the "2 of last 5" rule, while you will not be taxed on any gain you may realize on the sale, understand that you "WILL" pay taxes on the recaptured depreciation.

4. Will Capital Gains apply for both Federal and State? If you can suggest %

No, it will not apply to state unless your specific state allows for some kind of gains exclusion. I'm not aware of any state that does.

5. Since I will have to pay off Mortgage and HELOC post sale, will that reduce Capital Gains tax?

No. You can only deduct any interest paid on the loan, that can be "directly" attributed to the rental. So if you took out a HELOC on the rental to pay for your new primary residence, not one penny of the interest on the HELOC is deductible on SCH E. It's a SCH A itemized deduction.

6. If I reinvest the sale amount within 120 days paying off the mortgage balance and HELOC, will it avoid Capital Gains? Does the new investment has to be another real estate or can it be mutual fund, IRA, stocks, etc.?

That "reinvest" thingy when away back in 2010. What you do with the proceeds "has" "no" "effect" on the taxation of any gains realized on the sale of real estate of any type.

7. Would it be best to continue to rent or sell the property? I was thinking selling and applying the 2 of 5 year rule and avoid Capital Gains.

I'm not a financial advisor, so can't help you there. But understand that to qualify for the capital gains exclusion the property must have been your "PRIMARY" residence for at least 730 days of the last 1,826 days you owned it, counting back from the closing date of the sale.  Additionally, you can only take this exclusion once every two years.

[sk4000sk2]

Thank you. This was very helpful.

[AmeliesUncle]

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@sk4000sk wrote:

In Dec 2016, I purchased another property, which became my primary residence ... If I decide to sell the old property, say for 400K, and it closes in May/June 2020,

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That is 3.5 years of rental.  You are past the 2 out of 5 year rule, so it will be fully taxable.