Tax Benefits of Selling, Converting or Exchanging Your Real Estate Rental in '20/'21? For Many, Yes.
Updated: Sep 19
Many professionals inspired to invest in one or more residential real estate rental properties in recent to achieve their goal of earning stable passive income and positive annual cash flow are reevaluating their comfort with this asset, as most – it not all - didn’t factor the risk of an unprecedented event such as COVID-19 occurring that would prohibit the full and timely collection of monthly cash flow streams in accordance with lease terms and conditions.
As such, a percentage of professionals – and particularly those with suspended passive tax losses are rethinking their interests and options as COVID-19 has made it apparent the timely collection of monthly cash flow streams per lease term agreements has a higher level of risk than originally anticipated.
A percentage of professionals are cash flow negative for the year as they have been collecting less than 100% of monthly rent obligations yet continue to pay monthly property expense and maintenance obligations. To make up for cash flow shortfalls, they have been untimely liquidating portfolio holdings which will incur capital gains and NIIT tax – expenses not planned for or intended. And, with only 25% of unpaid rent accruing between September 1, 2020 and January 3, 2021 for COVID-19 related reasons due by February 1, 2021, many aren’t certain if and when they may collect any, a portion or all of accrued and overdue rent due in 2020 or 2021. And it’s making them uncomfortable.
Many have been fortunate enough to timely collect 100% of monthly rent due in-so-far in 2020. However with continued high new monthly unemployment claims they are aware future rent cash flow payments can end anytime, and exploring “Plan B” options to cover potential forward month cash inflow shortfalls.
As a result, a percentage of professionals with 1) vacant rentals, 2) rentals with tenants who will soon be moving out due to near-term lease expiration, who have expressed interest in breaking their lease or will do so in exchange for a modest cash payment, and 3) a percentage of those in a position to sell their rental while occupied (in accordance with lease terms and conditions and laws) are now actively re-evaluating their interest in and benefits of owning residential real estate long-term versus investing funds in other asset categories to achieve their cash flow and appreciation goals.
All have questions, including:
1. Will they receive tax benefits or experience negative tax consequences If they sell their rental in 2020/21 Specifically, how will their 2020/21 Federal and State marginal tax brackets, tax liabilities, tax cash outflow requirement and effective tax rates change, all else being equal?
2. What will happen to current year and accrued passive suspended tax losses?
3. Can losses be used to reduce household taxable income earned from W-2 salary, bonus and RSUs? If so, by how much?
4. If gains upon sell are projected, what is be the impact on 2020/21 tax cash outflows from capital gains, NIIT and other taxes?
5. Will they be subject to 1250 or 1245 depreciation recapture requiring a portion of certain gains be taxed at ordinary tax rates? If so, by what amount?
6. Can they write off uncollected 2020 rent as bad debt?
7. Is it advantageous to sell in 2020 vs. 2021 if taxable income will be significantly higher in 2021?
8. From a tax perspective, would it be beneficial to sell their primary residence in 2020/21 and take up residence in the rental for a few years?
9. Do expiring 2020 tax provisions make it more attractive to sell in 2020 or 2021?
10. Is a 1031 exchange viable?
As every professional asking questions has a unique financial, tax and household structure and unique rental property financial dynamics, risk tolerance for uncertain cash flow streams, excess cash and liquidity to cover unpaid rent shortfalls and interest in owning residential real estate vs. investing in alternate investment vehicles, there is not a one-size-fits-all answer to the questions many are asking.
To provide accurate answers, the first step is the updating of 2020/21 “current-state” baseline tax projections, and modeling the 2020/21 tax financial and tax impact of the sell of one or more rentals based on realistic price and related transaction assumptions and as necessary a multitude of additional financial moves the professional may be considering to execute on in 2020/21, and evaluating the results.
If, like colleagues at your level and above, 2020 has inspired you to actively re-evaluate life priorities and explore key life decisions previously not attractive or available, such as saying goodbye to California permanently, working remotely across state borders, a career change, launching a business or buying or selling a home or residential real estate rental – all decisions with significant tax consequences – let’s get our conversation started. “Back-of-the-envelope” envelope calculations are often misleading, and often lead to unfortunate and unnecessary negative year-end surprises.
If you aren’t anticipating any major life changes in 2020/21 but are running blind without accurate and updated 2020/21 tax projections incorporating tactical and strategic moves for which you qualify for and compliment your lifestyle objectives, give us a call and we will equip you with “current-state” baseline and multi-scenario 2020/21 tax projections, and advise you on if the effective tax rates you are on-track to achieve are more, less or equally competitive to the effective tax rates of those within your income range.
Let's get our conversation started - and your questions answered while time is still on your side in 2020 to position yourself ahead of the tax curve and close the year out strong.
Cobalt PacWest CPAs
303 Twin Dolphin Drive #600
Redwood Shores, CA 94065