When you sell your property, there are a broad range of choices on what you can do with the proceeds, so carefully planning your exit becomes an important part of the process to help optimize your tax consequence.
Many of these strategies center around the distinction between when the home is held as your residence and when it is held as an investment, and this can be changed to your advantage, but it takes time to establish which use you will need to report upon sale. If you have occupied the home for at least 2 out of the last 5 years, sale of your primary residence gives you the advantage of the homeowner’s capital gains exemption which allows a single person to take up to $250,000 and a married couple to take up to $500,000 of profit without owing any capital gains tax. And under the current rules you are also able to transfer a portion of your existing property tax base to your next home anywhere in the state with your new home exempt from having your property taxes increased up to a point.
Sellers who have owned their homes for a long time in our area often face substantial capital gains, and since the property tax transfer protection is limited to only the first $1 Million of price increase over that basis for the new property, some choose the strategy of moving out and renting their home for 2 years instead of selling it right away so that they can do a 1031 exchange to defer their capital gains. This strategy also requires that you operate the replacement property as an investment for an acceptable period of time before you can move into it, and most accountants say this should be at least 2 years, so the strategy usually involves a temporary interim living situation they likely would not have otherwise chosen.
If you’re buying an above-average home in Santa Cruz, its monthly fair market rents will likely be somewhere around $6,500. This puts the NOI at around $50,000, which translates to a relatively low Cap Rate of 2.9%. By contrast, apartments and commercial buildings typically are trading at Cap rates in the 5.5 to 6.5% range, meaning that they provide about twice the cash flow for the same investment, not including upside potential and appreciation, which can be greater with a Single Family Residence, depending on trending in the market where you invest. So even though a house in a high-end neighborhood is not typically a competitive income generator when its cash flow is compared to apartments and commercial rentals, the tax benefits you get are worth enduring the limited time frame you hold the replacement property as a rental.
One of the multiple cool things about a 1031 exchange is that you can roll the investment into multiple replacement properties, including Opportunity Zone investments where you end up having all the deferred capital gains permanently retired after 10 years. And it’s not necessary to use the entire proceeds for the exchange as long as you are okay paying taxes on the portion you don’t reinvest. In addition to the 1031 exchange, there are multiple other options available to the savvy seller, like setting up a Charitable Remainder Trust or rolling the proceeds into a Tenancy In Common investment or Delaware Statutory Trust. In all these cases it is important to plan in advance and of course get the advice of an experienced accountant or attorney, but with the right team to help you take the correct steps, you can end up in a much better financial position than would otherwise be possible.
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