[Legally] Pay ZERO Tax When Selling Real Estate Even If A Rental – 121 Exclusion & Depreciation Tips

– 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.

14 thoughts on “[Legally] Pay ZERO Tax When Selling Real Estate Even If A Rental – 121 Exclusion & Depreciation Tips

  1. what if you have 5 properties and you want to do this before you start renting them? I think this work with only 1 property each 2 years ! so I guess will need 10 years to get all the 5 properties under LLCs

  2. Can you own the S-Corp LLC or does it have to be someone else. Also what if I have a loan on my property? Do you know who can help me with this? Thanks

  3. What if you purchased the property with conventional financing? You also don't mention anything about recordation and transfer fees to the S Corp. that I'm guessing you'll incur on both sides (seller and purchaser).

  4. Hi Toby, Very good information. I have a primary house and I would like to benefit from 121 exclusion. I have a mortgage and a credit line on my primary house. I am not in a position to pay the loans and I would like to refinance or transfer loan to LLC. what are my options?

  5. I have 2 unincorporated self supported humanitarian foundations, and rental house that cost 160k I transferred before from my trust to the first foundation as bonified gift with 0 price. It possible to do Bonified Sale for 500K from one foundation to another, not C-Corporation, to avoid Capital Gains Taxes?

  6. Terrific stuff, but does this mean that real estate that fails the residency test (24 months out of the last 60) that is sold at a cost lower than the purchase cost, does not trigger a taxable event?

  7. I have a home with 1.2 million capital gain, so how can I combine section 121 and the 1031 exchange? Or some other solution.

Leave a Reply

Your email address will not be published. Required fields are marked *