- Hey guys!
Toby Mathis here with Anderson Business Advisors.
A question I get quite often is what to do
when I sell my house to make sure that I pay no tax,
and that one's pretty easy.
There's something called a 121 exclusion
which most people know that you have to have lived
in the house 24 of the previous 60 months prior to selling,
and you have to pass the ownership test.
You have to own it when you sell it.
And so, in English, it means that if I lived in the house,
it's one of my primary residences, or my personal residence,
and I had 24 months during that period of time,
and it qualifies, then I could qualify,
as a single person, a $250,000 exclusion against the gain,
the capital gains, not depreciation recapture,
that's important, against the gain on the home.
Or if I'm married filing jointly, it's 500,000.
So that's a big, huge capital gains exclusion
that you definitely want to capture.
Now, here's what sometimes happens.
Somebody purchases a house, the real estate market runs up
over the years, maybe they've been in it for 15 years,
20 years, and they want to sell it
and go move some place else.
And they say hey, how do I avoid the gain?
Sometimes they'll have a twist.
They say what if I want to keep it, and I want to make it
into a rental, then do I just put it into a rental?
Most of the time, practitioners are going to say yes,
and they just left a ton of money on the counter there
and they passed up the chance to use their 121 exclusion.
Here's why: that 24 of 60 month rule
applies to before you sell it.
You have to be the owner, and you had to have lived in it
for 24 months out of 60, but, if you were
renting it too long, you would lose that deduction entirely.
In other words, you get past three years, it's gone.
So if you're going to keep it and you're going to
make it into a rental, it does not
make sense to not use the 121 exclusion.
And then you're going to say, well, you can't use it.
Who do I sell it to?
I'm not going to sell it to somebody else.
How do I get to make it a rental property
and be selling it to somebody else?
How do I keep control of that, Toby?
Well, you have to think outside the box.
You can sell it to another taxpayer.
My business partner, Clint Coons, has done videos on this
and has done a really good job of explaining
how it works and the concept.
I'm just going to put a little more meat on the bones here.
All we're doing is we're literally taking you.
So let's say that I have a client,
as a person, you have a 1040.
You're the one who gets the 121 exclusion,
and we're going to sell it to another taxable entity.
The most obvious entity that is going to be the best
for the tax treatment on a rental property
is actually going to be an S-Corp.
And, so, we will make this into an S-Corp.
And when I say S-Corp, that means for federal tax purposes,
so it can be an LLC taxed as an S-Corp or a traditional
corporation that makes an S selection.
And all we're doing is selling it
at whatever the fair market value is.
It needs to be fair market value, something reasonable.
And, now, you will capture the 121 exclusion.
More importantly, so let's just use numbers.
Let's say that I bought my house,
let's just say it's $100,000.
I bought it for $100,000, and, now, it's worth $600,000.
I bought it, let's say it's me and my wife,
and we bought it, and we're looking
at a potential gain of $500,000.
And you say hey, I don't really want to sell it,
but I would like to not pay tax on that $500,000 ever.
You do the sale at $600,000.
The S-Corp agrees to pay you.
Now, a lot of you guys are going to say, wait a second,
where's the S-Corp going to get the money?
You need to have about 10-20% of the cash to make it
a bonafide sale, to make sure it's reasonable.
So you're going to want to make sure
that you fund the entity with something,
but the S-Corp can pay you over time
under an installment sale.
In other words, it doesn't have
to come up with all the cash now.
Maybe it comes up with $60,000 down.
What this will do is give you a new basis here of $600,000.
If you know how to do depreciation,
then you're going to take the land value,
and you're going to subtract that from this 600,000.
So 600,000, and you're going to get X number
of dollars to depreciate over 27.5 years.
So what's going to happen is you're going to get a large
amount of depreciation as a result.
You're also going to have a new basis of $600,000.
Which means, if in 10 years I decide to sell it
and it's gone up to 700,000, let's say,
then my only gain is the 100,000.
I literally am going to get to keep
the $500,000 off the books as far as taxation.
No tax on that $500,000 of gain because I chose to do this.
If I rent it, ordinarily if it was just me, and I turned
this into, converted it to a rental, my basis is $100,000.
That's what I'm using for my depreciation, not 100,000
I have to subtract off of the land value,
but I would only get to depreciate a small amount,
so I lose all that benefit, that means
that I'd pay tax on all the rents.
So, in English, I pay a lot more in tax.
Plus, I just screwed up, and I didn't get
my $500,000 capital gains exclusion.
So, let me go over how this works.
You have to form the S-Corp.
You have to make sure that when you're selling it
that you use an installment sale.
And, most importantly, you're using an installment sale,
but the entity is actually going to elect out
of treating it as an installment sale.
So the entity immediately says I am buying
this for $600,000, even though I'm paying it over time,
I'm treating it as though I bought it for $600,000.
All that means for you is you're recognizing
all that income, even though you
haven't been paid the money yet.
I'm recognizing all of the income
in the year that I sold it because
I want to use up that $500,000 big, huge, fat exclusion.
These are just tax elections so that the IRS believes
that I was paid the $600,000, in other words,
hey, I know it hasn't paid yet.
I know it's going to be paying over time, and it's paying,
how is it paying me, by the way?
It's paying with the rent?
Rent's come in.
It's paying me on the note, yay!
You know, I'm going to get the cash.
Now, the sale has to be a bonafide sale.
This is a big one.
It has to be for fair market value.
So, I'd actually get an appraisal.
I would literally go get an appraisal on it,
and I would probably use whatever amount is going to
give me the most bang for my buck.
I'm going to want to get as much of that $500,000 as I can.
So, this number may be different.
Maybe that's $500,000 that I'm sell it for,
and I'm only using $400,000 of it.
I just want to use up my 121 exclusion.
I don't want to leave it on the table.
And that 121 is in the year that I sell it.
That's me personally; I don't have to
recognize the gain when I do that.
And I hope that is starting to sink in
that we're literally taking something
that we would have lost all of that exclusion,
and that exclusion is worth quite a bit,
that could be $150,000 worth of exclusion
depending on where you live, your capital gains rate,
plus your state, plus your net investment income tax.
All these things start adding up.
Next thing you know, you're looking at a 33% tax
on $500,000, that's over $150,000
that you gave up of tax savings, not of deduction of tax
savings, like dollars you would have paid,
you quite literally, just by doing
this you save yourself $150,000.
Now, one red flag, big red flag.
Once that property is in that S-Corp,
if you ever take it out and give it to yourself,
that is going to be treated as ordinary income.
It's going to be treated just like the company paid you.
So you don't want to do that.
You want to make sure that you have a good tax advisor
to keep you from making mistakes,
but the rents still flow down as rents.
You have depreciation off-setting them.
There's a very good chance you're not going to
be paying any tax, depending on the numbers.
But if you have enough depreciation, there's a good chance
you're not going to have much of a tax bill on the rents
that you're receiving all those years
that's coming back into you, so it's a fantastic situation.
The only other thing you should be aware of is you
may be recognizing some interest on that note,
but it's peanuts in comparison to the amount that you're
going to capture and you're going to grab as the exclusion.
Very, very powerful technique, often times misunderstood.
Most practitioners can't get their mind around it,
so they immediately say no, there's no other option.
There's always an option, and the thing
you want to get in your head is how.
Always be asking how can I defer tax?
How can I avoid paying taxes?
It's absolutely legal to avoid taxes,
but the biggest thing is always starting off with
is there a way and how do I accomplish it?
You want to be asking folks like myself and my group
and Anderson Business Advisors and my partners,
are there ways to get around this?
And if somebody's immediate reaction is no, there's no way,
pass on them and go to the next one
to see if someone can actually dig into it.
There's usually some creative ways
to push things off into the future
or capture something that you are entitled to.
Like here, this big, huge, fat exclusion.
We don't want to leave it on the counter.
We don't want to leave it on the table for somebody else.
We just pass it up.
No, we want to capture that.
We want to have our cake and eat it too.
We want to have the step up, so
that we get higher depreciation.
And we want to capture our big,
fat, huge, capital gains exclusion.