Understanding the cost basis of a home. Rental property vs primary residence effects the taxes owed or the amount of profit excluded from tax.
Q: Two year ago, I relocated for my company and rented out my primary residence. My initial plan was for this to be temporary and to eventually move back into the property. However my move is turning into a long term assignment and I am planning on keeping the property as a rental.
My question is regarding the cost basis of the home. My home has doubled in value. Since I have lived in the home for two of the last four years, I was thinking about starting an LLC, selling the home to the LLC to step up in cost basis. This way I would be able to get the benefit of homeowner tax exclusion. Then I could keep the LLC as the business entity and have a more defined split of the personal and business expenses.
Am I overthinking this? Is this even a valid way to step up the cost basis while maintaining control of the property?
Understanding the cost basis of a home
A: Basically, you’re trying to have your cake and eat it, too. And, why not? If you could just sell the property to yourself, you’d step up the cost basis and start the tax clock ticking all over again.
The only problem is the IRS has rules and regulations that prohibit this sort of self-dealing. But there are other things you can do legally to minimize any future taxes on your profits.
For starters, the IRS gives you the benefit of not having to pay federal income taxes on up to $250,000 of profit on the sale of your primary residence. The main rule is that you must have lived in the residence for two out of the last five years. If you’re married, you get to exclude $500,000 in profits from federal income taxes.
From that standpoint, you appear to qualify for the home sale exclusion – but to get the exclusion, you have to sell the home. We can’t believe that the IRS would say that you “sold” the home when you end up controlling the home on the other end of the transaction. We’d think that the test the IRS would use would be whether the seller relinquished all ownership rights to the home and the buyer obtained all ownership rights as well. And your scheme doesn’t appear to pass.
Transferring property to a limited liability company
What you’re describing here is a situation where you own and control your home and convey your ownership interest to an LLC in which you have the controlling interest – it’s not an arm’s length transaction. You should also know that most of the time single member limited liability companies are generally disregarded by the IRS for tax purposes. This means that the IRS would still consider you the owner of the home.
To get the true benefit of the home sale exclusion, you need to sell the home in a form that lets the IRS know that the sale was a true sale and not a sham for the sole purpose of obtaining the home sale exclusion benefit today and giving the new LLC a property with the increased cost basis so you minimize taxes in the future as well.
You can certainly transfer your property to an LLC if your intent is not to obtain the home sale exclusion benefit from the IRS. But make sure that your mortgage company consents to the transfer of ownership. Remember, that your home loan documents provide that the lender has the right to call the loan due if you sell the property.
Selling a home for the home sale exclusion benefit
You may find that you’re better off simply selling the home and taking the home sale exclusion benefit. Let’s say you purchased the home for $250,000 and now sell it for $500,000. You won’t be taxed on the $250,000 in profit. That is a sizable amount of cash. If we say that your capital tax rate is 20 percent, plus the additional tax on the sale of real estate of 3.8 percent plus any other state taxes you have, you might otherwise pay upwards of $60,000 in taxes and perhaps lose other tax benefits due to your high income.
If you sell the property and pocket the profit, you can always buy a similar property in the same location or elsewhere if you want to go into real estate investing. That would make the whole thing a clean transaction.
Tax deductions for investment property owners
Since you’ve rented out the property for the last two years, have you already taken some of the tax deductions available to investment property owners? If so, that could affect your home sale exclusion. You should look at IRS Publication 523 (“Selling Your Home”) and go through the computations they give you. You should also look at IRS Publication 527, Residential Rental Property (which includes the rental of vacation homes). Given that you’ve rented the home, the IRS will require you to take that portion of the time your home was leased and carve that out of the exclusion.
It’s too complicated to go into all the details here, but you should know that once you started to rent the property, your property was no longer considered a primary residence. That change will have an effect on the taxes you will owe or the amount of profit you can exclude from tax. Your accountant, enrolled agent or tax preparer can provide you with specific information about your own situation.
Sorry we can’t give you the answer you were hoping for, but you should have known that it was too good to be true. Thanks for your question.
©2021 by Ilyce Glink and Samuel J. Tamkin.