Meet Jane. She is 75 and has owned a beach house for 32 years. She rents it out but at 75 she is finding it difficult to maintain and is considering selling it. In her younger years she and her husband enjoyed working on it together, and it was a nice project in their retirement, but since he passed away it has become a burden.
Jane has a son who wants her to be happy but also recognizes that if Jane sells, there may be severe tax consequences. Together they talk with Jane’s accountant and she helps them answer the following questions.
1. What are the tax consequences if Jane sells now?
Jane bought the house for $100,000 and it is fully paid off. If she sells the house for $735,000, she will walk away with about $500,000 in cash after paying selling expenses and taxes. Ouch!*
2. What are the tax consequences if Jane’s son inherits?
If her son inherits the property and sells it immediately he would not have to pay associated taxes since his basis will be same as the value of the property at death, it is “stepped up.” This is one of the gems of the tax law that is still favorable to taxpayers.
3. What is the cost of holding the property?
Not wanting to pay the huge tax bill to the government after working so hard for so many years on the house, Jane and her son discuss options. Fixed expenses of the property run about $11,000 a year. Gross rental income is about $18,000. Therefore, annual income, barring any large expenses is about $7,000 a year. Discretionary expenses vary for new appliances to a HVAC system, water heater, roof, etc. For estimate purpose, they assume that the rental income will net to zero. Since it might not make any money is the obvious answer to sell?
4. How does this real estate investment compare to other investments?
Jane is a conservative investor and has reached her comfort limit on the amount she will invest in the stock market. If Jane sells the property and invests the $500,000 conservatively and receives 4% return compounded monthly, in ten years she will have $745,000. However, real estate in this beach market will also increase. If they assume the value of the beach house grows at 4% annually, it would be worth $1,087,980 in ten years. Even if they assume that the value of the house grows at 2% annually, it is worth $896,000, still more than the $745,000.
If the discretionary spending is less than estimated, and the beach house does earn money each year, keeping the house becomes even more favorable. The $7,000 annual rental income over ten years is $96,000 of income at 4% compounded monthly.
And the winner (in this case) is...
Financially it makes the most sense for Jane to keep the beach house. However, decisions aren’t solely made on financial results. It is important to consider all the factors of a big financial decision and we are here to help you with that. In this case, Jane no longer wanted the stress of maintaining and managing the property. She decided to keep the beach house until she needs the cash for medical expenses as she ages while her son handles the management of the rental property. He will maximize rental days by offering it on the off season and handle the maintenance. Jane and her son feel that it is a win-win for both parties.
Do these questions still apply to me if I am in my 40’s?
Yes, you can use the same thought process to determine whether to buy or sell any rental property. In addition, to defer capital gains you can also consider a 1031 exchange or converting the rental into a primary residence.
*Selling expenses are 6% of 735,000 or $44,100. Since the property is fully depreciated, her capital gain is $690,900 (735,000-44,100). Depreciation recapture is taxed at 25%. The remaining capital gain is taxed at 20%. Federal taxes are estimated at (100,000*.25)+(690,900-100,000)*.2 or $143,000. State taxes at 5.5% are $38,000. Jane’s net cash out is 735,000-44,100-143,000-38,000= $509,900.