Property Owners, Avoid This Huge Income Tax Ticking Time Bomb!

Are you converting a current residence to a rental or have property you have rented for under 3 years that used to be your primary residence?

You need to read this important information and then schedule

Rental property income tax time bomb to avoid
Make Your CPA Appointment NOW to Avoid This Big Income Tax Time Bomb!

time with your CPA.  If you don’t have a CPA, you need to discuss avoiding this Income Tax Ticking Time Bomb!

Yesterday while in an attorney’s lobby waiting for the closing and just talking to the buyer, the buyer mentioned that his current residence which he is going to rent out after moving into this new home, has gone up in value significantly over the years.  So then the question comes up, “Are you going to sell the property in the near future?” and he said that his goal is to possibly sell the home in a few years.  Can you hear the sirens going off in our head after these statements?  You should, because this is where an experienced Realtor and Mortgage Loan Officer discuss selling timelines plus the potential to keep the rental property for long term investment.  The Realtor and loan officer should advise the property owner to speak to his CPA or he needs to find an experienced CPA to avoid a major tax bill and to take advantage of an often overlooked and beneficial tax law.

So What Should Property Owners Renting A Property Do?

First, this is not to be portrayed as tax advice but it is to inform you enough to contact an experienced tax professional to discuss your tax scenario.  So in this situation mentioned above, there are two important things that should have been heard and discussed:

  1. The Realtor should have heard another potential sale in the near future
  2. But more importantly, there is a big opportunity for the owner to sell and avoid a capital gains tax

So here is about how this conversation should go between the realtor and the property owner after he has closed and situated into his new home.

“Mr. Property Owner, since you mentioned you heard your property that you just turned into a rental has increased in value and that you may sell in the future, I figured I would validate that for you.  I have completed a thorough market analysis on your home and neighborhood.  This is not to talk you into selling now, but it is to give you the qualified information you need to know as a property owner so that you can plan effectively when and if you should sell.  This information is based on my research and knowledge of our local market.  The list price and value I have calculated is based on actual closed sales & current listings similar to your house.  I suggest that we review this type of new information every 6 – 12 months so that you again have the data to make the right decision in selling or continuing to rent out your property. ”  Then it is up to the realtor to put this on the calendar for regular follow up discussion

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Now, here is how the conversation could go about the timeline to avoid potential large income tax capital gains.

“Mr. Property Owner, are you familiar with how the capital gains income tax works when you have converted a primary residence to a rental property?  No?  OK, this is an area that can either cause you to pay a lot of income taxes that could be avoided or to sell within a time period where you do not pay any capital gain taxes.”  You now have the property owners attention as you should!  “A CPA can discuss a strategy so that if the market is right and you are making an acceptable profit on the property, you can save a lot of money.  Here are some summaries from the website and tax code which reference this potential COST or SAVINGS of $1,000’s to $10,000’s!”

Keep in mind that if an owner decides to keep the property as a long term rental, taxable gains are not realized until an actual sale.  So many property owners decide to take advantage of the potential tax benefits and wealth building attributes of rental properties.  Again, important to speak to an experienced Realtor, loan officer, and CPA.

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The IRS says you can exclude up to $250,000 of gain ($500,000 if married filing jointly) on the sale of your home if you meet the Eligibility Test Which is Summarized Below:

Eligibility Step 1:  Automatic Disqualification

  • You acquired the property through a 1031 exchange (like kind exchange) during the past 5 years
  • You are subject to expatriate tax

Eligibility Step 2:  Ownership

  • If you owned the home for at least 24 months during the last 5 years leading up to the date of sale (date of closing), you meet ownership requirement.  What does this tell the property owner above?  It is highly recommended that he review the numbers of selling the property within 3 years (so he would have lived in the house 2 of the last 5 years) to potentially pay no taxes rather than pay taxes after that 3 year date
  • If you received Form 1099-S, Proceeds from real estate transactions.  The date of sale appears in box 1 of Form 1099-S
  • If you did not receive Form 1099-S, the date of sale is either the date the title (deed) transferred or the date the economic burden and benefits of ownership shifted to the buyer, whichever date is earlier.

Eligibility Step 3:  Residence

  • Determine whether you meet the residence requirement.  If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period. It doesn’t even have to be a single block of time. All you need is a total of 24 months (730 days) of residence during the 5-year period.
  • If you were ever away from home, you need to determine whether that counts as time living at home or not. A vacation or other short absence counts as time you lived at home (even if you rented out your home while you were gone).
  • If you have a disability, and are physically or mentally unable to care for yourself, you only need to show that your home was your residence for at least 12 months out of the 5 years leading up to the date of sale. In addition, any time you spend living in a care facility (such as a nursing home) counts toward your residence requirement, so long as the facility has a license from a state or other political entity to care for people with your condition.
  • If you have more than one home, the IRS goes by their “facts and circumstances test”.  Click here to see the rules
  • If your home was destroyed, read the IRS Pub 547 Casualties, Disasters, or Thefts and if condemned see Pub 544
  • If you work for the government as uniformed or intelligence personnel, or are with the Peace Corps, you may be able to suspend the 5 year requirement and you should ask your tax professional about this

Eligibility Step 4:  Look back

  • Determine whether you meet the look back requirement.  If you did not exclude gain for selling a home on your tax returns for the previous two years (and you do not intend to do so on any returns or amended returns for the past two years that are not yet filed), you meet the look-back requirement.

Eligibility Step 5:  Exceptions

  • Ask your tax professional if there are any exceptions which the IRS allows certain property owners with events such as divorce, death of a spouse, marriage, sale of vacant land, home was destroyed, and others

The main thing to remember out of all of this, Talk to Your Tax Professional!  With good, strategic planning you can not just make a profit but you may be able to keep all of it!

Click here for the resource page used for this information

Our experienced loan officers are experienced in areas such as this and will do our best to point you in the right direction if a situation such as this arises.  We hope that you find this article helpful.

Related Resources:

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Written By: Russell Smith

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