Avoid paying tax when selling rental property?

With potential tax law changes, more restrictive rules on evictions,  and more tenant friendly legislation, some landlords are calling it quits. The low inventory and rising home prices doesn’t hurt either. So, if your landlording career is coming to an end – how do you sell your investment property and avoid paying more in taxes than you have to?

The general advice would be to use a 1031 Starker Exchange to transfer the proceeds into another investment property. But if you don’t want to deal with tenants anymore that kind of defeats the purpose. If you are willing to bear being a landlord for a while longer (or hire a management company), you can do a 1031 exchange into a property where you can see yourself living down the line (your intent has to be to rent the home out at least initially.) You could for example buy a home in a ski area, a mountain cabin, a home in Florida, a beach home on the outer banks. Rent it out for a few years, then move in and use it as your primary residence. While the tax consequences of doing that sort of conversion has changed, it could give you tax benefits long term when you eventually do sell and would also allow you to use the full amount of equity to provide yourself a home.

Another less known 1031 option would be to do a Delaware Statutory Trust 1031 Exchange (DST.) Your transaction would start like a normal 1031 Exchange, but instead of identifying and purchasing a replacement property you would transfer your proceeds into a qualified trust. This option allows for you to  pool your money with other investors and have a fractional interest in the assets of the trust. A DST is that a passive trust – little input from you as an investor is usually expected or possible. This lack of flexibility also applies to the ability to quickly dispose of it if needed. Typically, the life of the trust is 5 to 10 years and getting out before the end of the trust period may be expensive and difficult. Per an online estimate it appears a DST may be in the 6-7% return range and may be distributed monthly to your bank account. The minimum investment for a DST is typically $100,000. For more information see this and this.

Typically, the most immediately expensive option would be to just sell the home without using a 1031 exchange and “bank” the proceeds. Main issue with this strategy is that it could have significant tax consequences. First, you will need to do something called depreciation recapture of all the depreciation you took on the value of the property over the years. If the home is fully depreciated, that can be quite a chunk of money. You will also have to pay a federal and a state capital gains tax on the proceeds. And, to really cap it off – as a reward for making a profit, you may trigger the Alternative Minimum Tax (AMT.)  The only good news is that the AMT exemption amounts and phase out thresholds have been temporarily increased until 2025 due to the 2018 Tax Cuts and Jobs Act.

If you plan to sell your investment homes we would recommend you consult with your tax accountant before you decide to sell.