Help me understand rental property capital gains taxes and strategize

[feelingroovy]

Help me, please, mustachians, with a first-world problem.

We have a rental duplex that we purchased in 2004.  Since then, we've moved slightly further from it and I started a business which is doing well.  We have found that over the past few years, this rental has become feeling more of a burden and we'd be better off focusing our time and energy in the business.  That said, the numbers still work and we don't *have* to sell.

Current tenants are interested in buying it, which means we could avoid paying a realtor commission.

I asked my CPA about capital gains taxes and she said the capital gain + depreciation just gets added to taxable income and is taxed at marginal rates.  That didn't sound right to me and I questioned her, but she couldn't offer me any other info or strategies for avoiding this gain.

So I tried to work through a Schedule D Tax Worksheet.  There are definitely a few places I'm clearly not putting in the right numbers and am not sure what the instructions are referring to.  I did it twice and got very different answers.

Although this wouldn't go through until 2015, I used 2013 numbers to base it on, just to get an understanding.  Everything is rounded off to the nearest $1k, to keep math easier.

Please tell me if I'm understanding this correctly:

239k:  Expected selling price, after closing costs

169k:  Cost basis (from depreciation schedule)
56k:  Accumulated depreciation


 70k:  Capital Gain without depreciation
126k: Capital Gain plus depreciation recapture (239-(169-56))

 54k:  All other Taxable income (after adjustments and deductions; AGI was $82k))

My understanding was that the capital gains on the amount between $72500 and 54000 should be taxed at 0% and the rest (126k-72500) would be taxed at 15%, for a total of $8025.  This seems reasonable.  (I'm using all 2013 numbers just to keep it simple).

If I understand this correctly, though, this would make our AGI over $200k, so we won't qualify for some of our usual deductions, like IRAs.

But when I worked through the worksheet, I kept getting $0 taxed at 0% and a whole lot taxed at 25% and 28%, for a total of $38k in taxes.  This is enough to say, forget the whole thing.  We'll move in in a few years then sell after living there 2 years.

So I guess my first question is what IS my capital gains tax?  It seems worth the hassle of moving to avoid $38k in taxes, but not $8k.

Second, beyond moving in for two years before selling, are there other strategies to legally lower the amount?  Three that I've thought of:

1. Put a deal together with the buyers (our tenants) to hold a 3-5 year mortgage on 15% of the sales price.  They are planning on putting down only 5%, so this could help them avoid PMI and would spread our capital gains over a few years.

2. Live off the capital gains next year and don't draw a salary from the business.  Invest it back into the business, which should ultimately lead to higher income in future years.

3. 1031 exchange.  I'm not really interested in another rental property, but I could imagine buying an office building for my business.  I currently rent an office and we're starting to get squeezed--3 people in one room.

All of these have various pros and cons to me, and I am happy to discuss these.

Thanks!

(Edited to hopefully add clarity)

[Wile E. Coyote]

I am not sure I am following your numbers correctly.  Am I correct that your original cost basis was $169K, but you have since depreciated $56K of that so that your tax basis in $113K?  If that's the case, then when you sell for $239K your gain of $126K will be treated as ordinary income to the extent of the depreciation recapture of $56K and the remaining $70K will be capital gain.

In addition, it sounds like you have 82K of other taxable income, for total AGI of about $208K.  With that much AGI, all of your capital gains will be taxed at 15%, so I think your calculation using the worksheet is likely correct.

Is your business in a C corporation?  If not (i.e., it is an LLC that has not elected to be taxed as a corporation or it is a partnership), then it doesn't matter if you draw a salary or not as the income will flow through to your return regardless. 

I think they changed the rules related to converting a rental into a primary residence in an attempt to rely on the exclusion from gain on sale of a principal residence, so that may not be quite as simple as you may be thinking.

[Wile E. Coyote]

Here is a link to a discussion of the change to the rules when trying to convert rental property to a principal residence.

http://www.kitces.com/blog/limits-to-converting-rental-property-into-a-primary-residence-to-plan-for-irc-section-121-capital-gains-exclusion/

Short summary is that you will still have to recognize gain attributable to the time that it was rental property and you will still have to recapture the depreciation as ordinary income.

[feelingroovy]

Thanks so much, Wile E.

Yes, you've got the numbers right.

So the $56k of depreciation recapture will be ordinary income and the $70k of pure gain will be taxed at 15%?

That article is very helpful.  I figured it wouldn't be as simple as we can exclude the whole thing.

Maybe it's because I've never had a really high income but the idea of paying this much of the gains into taxes is just choking me.  I realize that the depreciation was really tax deferral and it's time to pay the piper, but of course, with the business doing well, our regular income is now higher than ever before.

My business is currently an LLC and taxed as a sole proprietor.  I realize there is no difference between my "salary" and "profits."  My idea was basically that b/c we'd have the money from the house sale, I wouldn't need any salary or profit (which I currently use to support my family and fund the stache) and could basically spend *all* the business revenue on the business, reducing profit to near 0.  This would make my regular income (the 82k AGI that I had without the house sale) close to 0.  I would, of course, spend in areas that would increase sales and ultimately profit, like marketing.  Or hiring another employee, who would ultimately bring in more revenue.

That said, the other part of the conversation with the CPA was to apply to have the LLC taxed as an S Corp to reduce SE tax for 2015.  That is chump change compared to the capital gains, though.  I think this move would mean I couldn't *not* take a reasonable true-through-payroll salary.

I suppose the other option is to hold onto the house forever and get a property manager. 

[MDM]

Reminds me of this: https://twitter.com/padresteve/status/274374727953420289

Could be worse problems to have - good luck!

[GizmoTX]

Sole proprietors, partnerships, Sub-S corporations, & LLCs all get taxed the same way: passed thru to the owner's individual tax return.
A C-Corp gets taxed twice, once on its profits, & again on distributions to shareholders -- not the way to go.
Capital gains taxes are lower than ordinary short-term income, wages, or salary.

[Wile E. Coyote]

That said, the other part of the conversation with the CPA was to apply to have the LLC taxed as an S Corp to reduce SE tax for 2015.  That is chump change compared to the capital gains, though.  I think this move would mean I couldn't *not* take a reasonable true-through-payroll salary.
 

If you do not pay yourself a reasonable salary for the services performed, the IRS will challenge, likely successfully, and a portion of any distributions from the S Corporation may be rechracterized as salary to bring your salary up to a reasonable amount for the services performed.

[feelingroovy]

That said, the other part of the conversation with the CPA was to apply to have the LLC taxed as an S Corp to reduce SE tax for 2015.  That is chump change compared to the capital gains, though.  I think this move would mean I couldn't *not* take a reasonable true-through-payroll salary.
 

If you do not pay yourself a reasonable salary for the services performed, the IRS will challenge, likely successfully, and a portion of any distributions from the S Corporation may be rechracterized as salary to bring your salary up to a reasonable amount for the services performed.

Yeah, that's my understanding.  But I haven't switched to the S Corp yet.  We were going to do that beginning of 2015.  So this strategy would be to delay that. 

Of course, I'd rather just put any extra money into index funds.  This seems like a more risky investment, in a way, investing it back into my business.  Or at least, I'd feel the pressure to see an immediate return on investment.

What does everyone think of the 1031 into an office building for the business?  Or structuring the sale so that the gains are spread over multiple years?  There must be other strategies.

Or heck, just keeping it?  We're still 8 or so years from FI and this rental kicks off more than a 4% safe withdrawal would.  We were just looking for simplifying life.

[MooseOutFront]

Sure would be nice to wait to sell it in a bad year, but it would also be nice not to have any bad years.

[Cheddar Stacker]

My first choice would be hold it and hire a property manager if it's worth keeping.

Second choice, installment sale. Seller financed as you already alluded to. This spreads the gain over multiple years and reduces taxes overall.

Third choice, sell it outright and pay the tax.

Fourth choice, 1031. Drawback here is you reduce all future tax depreciation of the new building, and you pay a bigger tax when you sell the next building.

Did this rental ever have tax losses? Check your 2013 return for "passive loss carryovers". If you have those, they become a deduction in the year of sale and should offset some of the gain.

[feelingroovy]

Thanks, everyone.  This is really helpful and I now have a much better understanding of the difference between the taxes on the actual capital gains rates and the depreciation recapture. 

It's the latter that I think is the big issue.  Adding that $56k to our regular income moves us from safely inside the 15% bracket and being able to use TradIRA deductions to much higher brackets and ineligibility.

The other issue is we live in NY, which has high income tax rates, especially for high incomes (and high property tax rates--yay us!).  I haven't even looked into what the sale would do to our state taxes.

So it seems that really we should keep this property.  Sigh.  It will be paid off in 13.5 years and at that point we'll gain an extra $1150/month income, which will be awesome.  Even with a property manager I know it's going to take some looking over.

We had originally bought it when the kids were tiny with the idea that we'd sell it to pay for at least a large part of college.  Well, the oldest is now about to start high school, so we're getting close.  Since finding MMM, I realize we'd be better off keeping it for the retirement income, but it's become a distraction from working on my business.

We're still 8-10 years from FI and getting two kids through college, so I hate to take an action now that will eat up a lot of our assets.

So my next steps are to research how to structure an installment sale and property managers.

[sol]

I'm dealing with a similar situation, and my understanding was that depreciation recapture would be taxed at 25% regardless of income, and then any gains on top of the adjusted cost basis (basically purchase price plus any improvements) would be taxed at the LTCG rate appropriate to your income bracket, which would be 0 in your case because you're in the 15% bracket.

Is that not what I'm reading here?  I thought LTCG were taxed in gradational brackets, like your earned income, so that you paid 0% on the first $73,800 (if MFJ) and then 15% on amounts over that.

[Cheddar Stacker]

DSorta sol, but the depreciation recapture income alone will put them most of the way into the 25% bracket. If ordinary income gets you into the 25% bracket you pay 15% tax on cap gains. If cap gains get you into the 25% bracket the portion down in the 15% bracket is taxed at 0%, then the 25% portion is taxed at 15%.

If they can't deduct T.IRAs they won't have any 0% cap gain taxes without some major itemized deductions.

[feelingroovy]

I had understood it somewhat like Sol did, but I thought the depreciation recapture was part of the "capital gains," taxed at 0% or 15%.  But it sounds like the depreciation recapture is added to ordinary taxable income and that is the number used to determine which tax bracket you're in. 

(And based on my likely incorrect attempt at filling out a Schedule D, I think even the pure gain is also being added to determine Taxable Income.  You're just computing the tax differently than using tax tables).

It makes me realize that the depreciation we've been taking all along was really just a tax deferral.  What stinks for us personally is our income has been rather low for the past 6 years (until 2013) as my business was getting going--I was plowing nearly all of the (small) revenue back into the business.  So I was deferring about $6k of income in rental depreciation each year when our income was really low anyway.  Now when I go to sell, my regular income is already higher and that depreciation all gets added to our income in a single year, pushing everything into a higher bracket.

I think I need to be more strategic about selling in a year when other income is low, which may not be until the kids are out of college.  Of course, by then the accumulated depreciation will be double.

Between this capital gain/depreciation recapture issue and equity in a rental counting against financial aid, we may need to sell our current house and move into the rental before college.  Decisions like this are so hard, though, b/c you just don't know how much you're going to need for college until you're there.