Learn from Toby Mathis, Esq. how to use two powerful strategies that, when combined, can save you tens of thousands in unnecessary taxes.
A question I receive all the time is: How can I sell my house without paying any taxes? You may be surprised, but the answer is easy. There are steps involved, but using the 121 exclusion makes it doable.
The 121 exclusion allows a taxpayer to exclude gains (up to certain thresholds) on the sale of a primary residence from taxation. To qualify for the 121 exclusion, you must have lived in the house for 24 of the last 60 months. If this test is met, then the property owner can sell the house and exclude up to certain amounts of gain from taxation. This exclusion means you do not pay tax on the gain. If you’re single, the 121 exclusion limit is $250,000, and it’s $500,000 if you’re married filing jointly.
It’s important to note that the $250,000/$500,000 exclusion is against the gain (capital gains, not depreciation recapture — that’s important). This is a huge, juicy exclusion that you should absolutely utilize with the guidance of a tax advisor.
If you bought your home for a certain amount but it’s gone up in value since the original purchase, the value increase is considered a capital gain upon the sale of the property. With a 121 exclusion, you can sell and pay zero tax on the gain, up to the aforementioned limits.
What If I Want to Keep It as a Rental?
Most practitioners, including tax attorneys, CPAs, accountants, and others, will tell you that you can’t sell your home and still keep the property as a rental. In doing so, they’ve passed up on a chance to use the 121 exclusion, thereby leaving tons of cash on the table.
Keep in mind that the rule stating you must have lived in the property for 24 out of the last 60 months applies before you sell it. If you rent the property for too long, you lose this exclusion entirely. And once it’s gone, it’s gone.
If you want to keep the property as a rental, it does NOT make sense to ignore this massive tax-saver.
In this case, you may be wondering: Well, who would I even sell it to? How do I make it a rental property while selling it at the same time? How would I keep control in that scenario?
We’ve got to think outside the box here.
One important point right off the bat is that you must sell it to another taxpayer, but remember that entities are taxpayers. You as an individual filing a 1040 tax return will get the 121 exclusion, but the buyer can be another taxpayer.
Since we want to turn the property into a rental, I would recommend an S corporation. I recommend an S corp in this situation because this is the entity that receives the best tax treatment for rental properties. Note that the S corp can be a traditional corporation that makes an “S” election or an LLC taxed as an S corp.
So, you sell the property at fair market value to an S corporation you set up. This is critical: you must sell the property for fair market value. Otherwise, you’re looking at trouble.
As an example, let’s say that a married couple filing a joint tax return bought a house 15 years ago for $100,000. Today, the house is worth $600,000, leaving the couple with a potential gain of $500,000, on which they would owe taxes. They don’t want to sell it, but also don’t want to ever pay taxes on that $500,000 of gain.
This example couple should sell the property to their S corporation for $600,000 under an installment sale. Now, where does the S corp get the money? The S corp needs to have 10%-20% of the purchase price in cash in order to make sure the sale is bonafide and legitimate. Thus, you’ll need to fund the entity with the appropriate amount.
The S corp can then pay the couple over time under an installment sale. The entity does not have to come up with all the cash now, just 10%-20%. This will give the couple a new tax basis in the property of $600,000.
Next, if you know how to perform depreciation, take the land value and subtract it from the sale price. Depreciate the difference over 27.5 years. As you can see, this is a HUGE amount of depreciation.
If you choose to go straight to converting the property to a rental without using this strategy, your tax basis in the property would remain at $100,000. Without the 121 exclusion strategy discussed above, you’d only be able to depreciate a tiny amount ($100,000 minus the value of the land). Not only would you lose all that, but you’d also owe taxes on all the rents. Ultimately, not using this strategy will cost you significantly.
Steps to Success with the 121 Exclusion & Depreciation
- Form the S corporation
- Request an appraisal of the property to determine its fair market value
- Use an installment sale to sell the property to the S corporation
The sale must be bonafide and for fair market value, so I would recommend getting an appraisal. Use whatever amount will give you the highest exclusion within the limits.
Most importantly, you’re using an installment sale to sell to the S corp, but the entity will elect out of treating it as an installment sale. The entity buys the property for fair market value, even if the entity’s paying over time. What this means for you as the seller is that you recognize all of the income in the year you sold the property (even though you haven’t been paid it yet) because you want to use up your full 121 exclusion.
How does the S corp pay for this note, by the way? With the rents it collects. Depreciation will offset your rents, so there’s a high likelihood that you won’t be paying tax on the rents you’ll receive over the years.
Then, in the year you sell, you as an individual taxpayer (or married couple filing jointly) don’t have to recognize the gain on that sale (meaning you don’t pay tax on the gain).
A Word of Caution on the 121 Exclusion & Depreciation
This strategy is excellent to save tens or possibly even hundreds of thousands of dollars in overpaid taxes. That being said, it’s important that you work with a qualified tax advisor to make sure you don’t make any mistakes. For instance, if you ever take the property out of the S corp and give it to yourself, that will be treated as ordinary taxable income to you — so don’t do that.
Where There’s a Will, There’s a Way
Most practitioners can’t get their heads around this strategy fully, so they just say “no.” But there’s always a way. Ask, “How can I defer taxes? How can I avoid taxes? Are there ways to get around this?” If someone’s immediate reaction is “No, there’s no way,” move along to another professional. They aren’t knowledgeable enough if they can’t think of a way — there’s almost always a way.
This is a huge tax benefit that many people leave on the table because they don’t understand how it works. Don’t let this be you. If you’re not sure how to take full advantage of this or any other tax strategy, I encourage you to take advantage of our complimentary Strategy Session. One of our Senior Advisors will be happy to walk you through the steps to use this method to your benefit. You can schedule your Strategy Session online or by calling 800.706.4741.