Real estate is an attractive investment opportunity, but investors need to be prepared for potential taxes to truly maximize their profits. New investors may be unaware that taxation differs depending on how they acquired the property and how it is being used. Common means of acquiring a property include simply purchasing it, inheriting it, or receiving it as a gift—and each comes with its own tax implications.
One popular but potentially tricky way to monetize real estate is to convert a primary residence into a residential rental property. This strategy has the potential to qualify for the Section 121 exclusion, which allows a taxpayer to sell their primary residence and exclude up to $250,000 of the gain (or $500,000 for married couples filing jointly) as long as the property qualifies as their primary residence within a certain time period.
To qualify, the property needs to have been the taxpayer’s primary residence for at least two years out of the last five years since the date of sale. This means that the property owner needs to be especially mindful of their move-out date and the date of sale. For example, if an owner moves out of their residence in January 2020, then they would ideally sell the property by January 2023 to qualify for the Section 121 exclusion. In this case, the last five years would span January 2018 to January 2023 and the two-year minimum would be met from January 2018 to January 2020, assuming that the property was their primary residence throughout this period. Another approach is to move back into the property for a period of time to ensure the requirements will be met.
Another strategy is to sell the property to an entity owned by the taxpayer, such as an S corporation, before converting it into a rental. This allows the owner to secure the 121 exclusion by gaining more control over the timeline for the sale. In this case, the owner will want to sell the property at fair market value. They will also want to wait until after they have claimed the 121 exclusion to convert the property into a rental.
If the sales price is less than that $250,000 exclusion (or $500,000, depending on your filing status), we have a tax-free sale! The property also receives a step up in basis, so when it is placed in service as a rental, the depreciation basis is now much higher, so tax deductions going forward will be higher on an annual basis. So this strategy can be more tax-advantaged than simply moving out of a property, turning it into a rental, and then dealing with the taxes down the road.
Aspiring investors also need to discern between effective strategies and unsubstantiated advice. For example, one popularized idea is that a property owner can simply open an LLC and contribute their primary residence to the entity to receive tax deductions, including depreciation benefits. However, the popularity of LLCs has to do with asset protection, not tax benefits. Simply placing a residence in an LLC will not change the fact that the residence is still for personal use and is not eligible for the special tax deductions investors are usually seeking.
Another commonly-heard myth is that putting real estate into an entity enables the owner to deduct any losses from that property. On the contrary, most real estate rentals are classified as passive under Section 469, and an overall loss on a passive activity does not automatically qualify for a tax deduction. The taxpayer will still have to apply a specific tax strategy, such as income recharacterization, to secure a legal deduction.
Overall, investors looking to generate income from a residence need to understand how the use of the property and the timeline for changes in use impact their options for tax deductions. To learn more about tax strategies for real estate investing and become better equipped to advise your clients, become a Certified Tax Planner today.
