Michael Kitces explains capital gains exclusions on rental properties

[Nords]

I met Michael briefly at FinCon12 and enjoyed talking with him-- a very bright brain in a very driven man.  A few months ago he gave one of the best explanations I've ever read about Roth IRA conversion ladders:
http://the-military-guide.com/2014/03/20/early-withdrawals-from-your-tsp-and-ira-after-the-military/

and a few months before that he helped me understand how IRMAA can cost you some of your Medicare benefits if you rebalance and take too many capital gains:
http://the-military-guide.com/2014/01/02/how-i-cost-my-dad-over-2000-in-medicare-benefits/

His latest post explains how to exclude capital gains on rental properties and gives the history of how this loophole has shrunk to a pinhole.  It can still be partially accomplished in many cases, but of course it's not as good as it used to be.  He also explains the difference between the capital gains exclusion and depreciation recapture.  If you've read about these subjects before then I think you'll appreciate a clear explanation with many examples.  If you've never read about this before-- especially if you're a landlord-- then you have some reading to do.

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

The part that I appreciate the most is a situation encountered by many military "accidental landlords":  they buy a house at a duty station (for whatever reason, with the best of intentions) only to have to move to a new location.  They can't always sell when they move (for whatever reason) so they end up being involuntary landlords.  Kitces' post explains how to handle the sale of the house (with or without tenants) for up to three years after it's no longer their primary residence... and how to treat it after that.

I used to read these arcane sections of the tax code and think "Heh-- that'll never happen to me."  Well, buried deep in my tax records is a piece of paper from 1989 that documents a capital gains exclusion (rollover) from the sale of a primary residence to purchase a new primary residence.  A few years later we turned it from a primary residence into a rental property, and we're still landlords.  I've been hanging on to that stupid piece of paper for 25 years, and I'll probably have to hang on to it until after we sell the property it was rolled over to... or let my executrix deal with it. 

So if you're planning to someday try to shelter capital gains on the sale of a piece of rental property, then this post is worth keeping in your own tax files.

[j-lu]

Thanks for posting this, Nords.  We are a military family who has hung on to a few properties in lieu of selling.  As we near our retirement we will need to sort out what makes the most financial sense.  This article will come in handy. 

[Cheddar Stacker]

Thanks Nords. Seems like this will be most useful for people who have been long-time real estate investors already, but definitely some good information for everyone to consider.

[Bearded Man]

I think you are talking about a 10-31 exchange. Pretty common amongst RE investors IMO (I've got 4 years in November and even I know that lol). I actually plan on doing a 10-31 exchange if my tenant wants to stay yet another year when the lease expires again. I intend to use the money to buy a smaller cottage in the sticks to retire to, away from the ghetto that the US is rapidly turning into.

[arebelspy]

For those googling, 1031 isn't hyphenated.

[Nords]

Thanks for posting this, Nords.  We are a military family who has hung on to a few properties in lieu of selling.  As we near our retirement we will need to sort out what makes the most financial sense.  This article will come in handy.

Glad it helps-- and it's good to see you posting here!

I think you are talking about a 10-31 exchange. Pretty common amongst RE investors IMO (I've got 4 years in November and even I know that lol). I actually plan on doing a 10-31 exchange if my tenant wants to stay yet another year when the lease expires again. I intend to use the money to buy a smaller cottage in the sticks to retire to, away from the ghetto that the US is rapidly turning into.

Um, no.  If I'd been referring to a 1031 exchange then Michael would have written the post about Section 1031 of the IRS code, not Section 121.

I'm not a CPA, but perhaps a 1031 is more of a deferral of capital gains rather than an exclusion.  The "problem" with a 1031 is that after it's finished you still have real estate (or at best, a managed TIC property).  I'm interested in the article's clear explanation of the situation where a military servicemember ends up hanging on to real estate for a few years after a transfer (as a long-distance landlord) and then wants to sell it without exchanging it for another property.   

While a 1031 might defer capital gains, I think depreciation recapture tax would still be due.  But again I'm still not a CPA.

For those googling, 1031 isn't hyphenated.

Well, I guess it could be:  "10-31:  Crime in progress"

There seems to be a cottage SEO industry about punctuation.  Typing "10 31" into Google produces sites with the phrase written as "10 31", "10/31", 10:31", and so forth.  I wonder what they're trying to achieve.

[arebelspy]

Just read the article. 

Very well done.

Confirms I probably won't ever use it, or if I do it will be for a very small amount, but I definitely understand it much better now for when people ask questions.  I really appreciate his clear, straightforward explanations and examples.

Thanks for sharing Nords!

[Milspecstache]

Great article and for military there is an added twist that allows you to delay the sale for 10 years and still claim the exemption:
http://personal-finance.military.com/2013/08/home-sale-capital-gain-tax-exclusion-for-military-members.html

[Nords]

Just read the article. 

Very well done.

Confirms I probably won't ever use it, or if I do it will be for a very small amount, but I definitely understand it much better now for when people ask questions.  I really appreciate his clear, straightforward explanations and examples.

Thanks for sharing Nords!

He's done "clear, straightforward, and examples" three times for me so far...

Great article and for military there is an added twist that allows you to delay the sale for 10 years and still claim the exemption:
http://personal-finance.military.com/2013/08/home-sale-capital-gain-tax-exclusion-for-military-members.html

Great point-- I completely forgot about that, thanks!