Ginny, we have a rental property that we would like to sell to our son and his wife. The problem is that we have not lived in the house as our primary residence for the required two years and therefore would have to pay a considerable amount in capital gains. Is there any kind of rent-to-buy or reverse mortgage or other arrangement that would make this possible without our facing a large tax bite? Darrell J., Discovery Bay, CA
Darrell, your question seems to mix two concepts when it comes to taxing real estate sales. If you own a home, use it as your primary residence and have lived in it for two out of the last five years, you can exclude from any taxes up to $250,000 in profits if you are single and up to $500,000 in profits if you are married. That’s the way it would work for personal residences.
Now if the home isn’t your primary residence and you sell it, you’d have to pay the tax on the profits on the sale of your second or vacation or investment home. The taxes on a second home sale could be significant, but remember that your taxes would be at capital gains rates and could be substantially less than if you were taxed at ordinary tax rates.
For a substantial sale, the taxes on a sale when taxed at capital gains rates would be around 24 percent; but if you sell and pay taxes at ordinary rates, you might pay around 40 percent. (We’ve rounded figures and included the 3.8 percent Net Investment Income Tax, often referred to as the Medicare Tax, which may be rescinded depending on what happens this year in Congress.)
You indicated that your property is a rental property. As a rental property, you could sell it and defer paying any federal income taxes if you plan ahead and use a 1031 tax deferred exchange. When you use an exchange, you are selling one property to then buy another property. You’d have up to 45 days after your sale to designate a replacement property and up to 180 days to close on the replacement property. So if you were planning to buy more rental properties, this is the way you should go.
Having said all that, if your plan does not include owning more homes or properties and you want to sell it to your son and his wife, we’d really suggest that you talk to an accountant, because our next suggestion would be to sell it to them on an installment basis; that is, you become their lender and sell the property to them over time. Installment sales, however, can be complicated. Without knowing any other issues you might have tax-wise, you would likely need some professional help.
There are ways to structure installment contracts to allow you to pay federal income tax as you receive the money from your son and his wife. You would still pay taxes, but you might pay at a lower rate and pay over a longer period of time. Whether this is better for you or not, we don’t know. It may be an option for you, but you’ll need to know what your taxes might be if you sold outright versus what your taxes might be if you sell on an installment basis.
Given the possible changes in the income tax code that could come up, there could be benefits in doing it over time. Then again, we don’t know what those changes might be and how any changes would affect you. Please consult with your tax preparer and a real estate attorney so that you document the sale correctly.