How Do I Correct Excess Roth IRA Contributions?

How Do I Correct Excess Roth IRA Contributions?

 

Co-written by: Scott Christensen & Katherine Li

 

Contributing to a Roth IRA is a great way to receive tax benefits for retirement savers. If you already do or are planning to take advantage of this tax savings vehicle, it is important to familiarize yourself with the rules that govern these accounts. The IRS has put in place strict limits regarding the amount that individuals can contribute to their Roth IRAs, as well as income limits for determining who qualifies.

 

If you are a single tax filer, you must have Modified Adjusted Growth Income (MAGI) under $140,000 in order to contribute to your Roth IRA. The amount you can contribute to your Roth IRA begins to phase out starting at a MAGI of $125,000; if your MAGI is greater than $140,000, you can no longer contribute to the Roth IRA. For those who file as married filing jointly, your MAGI must be under $208,000 in order to contribute. The phaseout range in this case applies to those with a MAGI between $198,000 and $208,000. The maximum IRA contribution in either case is $6,000 for those under 50 and $7,000 for those 50 and older.

 

As a result of these strict limits, it is easy for taxpayers to overcontribute. So what happens when taxpayers contribute in excess of their contribution limit?

 

For every year that your excess contribution goes uncorrected, you must pay a 6% excise tax on the excess contribution. In order to avoid the 6% tax penalty, you must remove the excess contributions in addition to any earnings or losses on that excess contribution by the tax filing deadline in April. To determine your earnings on your excess contribution, you can use the net attributable income (NIA) formula.

 

Net income = Excess contribution x (Adjusted closing balance – Adjusted opening balance) / Adjusted opening balance

 

Note: If you find that you have losses on your excess contribution, you can subtract that loss from the amount of your excess contribution that you have to withdraw.

 

Reasons for Overcontribution

 

  • You’ve contributed more than the annual amount allowed.
    • Remember that the $6,000 and $7,000 dollar maximum applies to the combined total that you can contribute to your Traditional and Roth IRAs.
  • You’ve contributed more than your earned income.
  • Your income was too high to contribute to a Roth IRA.
    • Unfortunately, single tax filers who make $140,000 or more and those who are married filing jointly who make $208,000 or more are unable to contribute to a Roth IRA.
  • Required minimum distributions (RMDs) are rolled over.
    • RMDs cannot be rolled over to a Roth IRA.
      • If it is rolled over to a Roth IRA, the amount will be treated as an excess contribution.

 

Removal of Excess Prior to Tax Filing Deadline

 

If you find that you have overcontributed prior to filing your tax return and prior to the tax filing deadline, you can remove your excess contributions before the tax filing deadline (typically April 15) and avoid the 6% excise tax. However, your earnings from your excess contribution will be taxed as ordinary income. Additionally, those who are under 59 and a half will have to pay a 10% tax for early withdrawal on earnings from excess contributions.

  • Keep in mind that it is your earnings that are subject to an ordinary income and early withdrawal tax, not the amount of your excess contribution.

 

If you find that you have overcontributed after filing your tax return, you can still avoid the 6% excise tax if you are able to remove your excess contribution and earnings and file an amended tax return by the October extended deadline (typically October 15). 

 

Recharacterization 

 

Recharacterization involves transferring your excess contribution and any earnings from your Roth IRA to a Traditional IRA. In order to avoid the 6% excise tax, you would have to complete this transfer process within the same tax year. It is also important to note that you can’t contribute more than your total allowable maximum contribution. Thus, you must make sure that you can still contribute more to your Traditional IRA prior to proceeding with recharacterization.

 

Apply the Excess Contribution to Next Year

 

You can offset your excess contribution by lowering the amount of your contribution the following year by the excess amount. For example, say that you contributed $7,000 to your Roth IRA when the maximum amount that you could contribute was $6,000. The next year, you can offset this excess amount of $1,000 by limiting your contribution to $5,000. You are, however, still subject to the 6% excise tax due to the fact that you were unable to correct the excess amount by the tax filing deadline, but you won’t have to deal with withdrawals. 

 

Withdraw the Excess the Next Year

 

If you choose to withdraw the excess the following year, you will only have to remove the amount of your excess contribution, not any earnings. However, you will be subject to a 6% excise tax for each year that your excess remains in the IRA.

 

These rules can be confusing to navigate which is why we recommend involving your tax accountant or trusted advisor in these situations. We are happy to connect you with a Merriman advisor to discuss your situation.

 

 

Sources:

https://www08.wellsfargomedia.com/assets/pdf/personal/goals-retirement/taxes-and-retirement-planning/correct-excess-IRA-contributions.pdf

https://www.nerdwallet.com/article/investing/excess-contribution-to-ira

https://investor.vanguard.com/ira/excess-contribution

https://www.fool.com/retirement/plans/roth-ira/excess-contribution/

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.

 

Buying a Car: Does It Make Sense to Use Rideshare Instead?

Buying a Car: Does It Make Sense to Use Rideshare Instead?

 

The decision to buy a car today is different than it was a decade ago because of today’s rideshare options. If you’re in the market for a new car, there’s more to think about than shopping for the lowest price or best interest rate. Have you compared the cost of your car to the cost of using rideshare options? We have, and we’d like to share our thoughts.

Cost. Let’s compare some estimated costs of buying a car or using rideshare:

Using rideshare may cost about $7,500 less over a 10-year period—which is not a trivial amount. Keep in mind, this excludes other expenses people often pay when owning a car, such as parking fees or toll fares. For many people, owning a car is probably more expensive than our estimate. However, we’ve kept things simple here, so our cost estimates may differ from your actual costs for both owning a car and using rideshare. In addition to cost, there are other factors to consider.

Lifestyle. Your lifestyle probably also plays a part in your decision to own a car or use rideshare. Let’s meet two different couples who said just that and examine some aspects of their lifestyles:

Judy and Joe are both 35, have two kids ages 8 and 10, and a dog. They live in a house and have two cars parked in their garage.

Kim and Kyle are both 32, don’t have kids, and have two cats. They live in a condo and have two cars, which they both pay to park in their building’s garage.

Location. Location determines a big part of our lifestyles. If you live in a metropolitan area, you’ve probably spent a lot of time considering where you live, where you work, and what your commute is like. Wherever you live, do you commute to work by car? Is having your car a “must”? Here’s what Judy and Joe’s and Kim and Kyle’s locations look like:

Judy and Joe live in Redmond, and both commute to Seattle for work. Their morning commute consists of a 10-minute drive to their nearest park-and-ride, followed by a 40-minute bus ride into Seattle.

Kim and Kyle’s condo is located in downtown Seattle, and they both commute to work on foot. Their daily commute is about a 20-minute walk each way, but they’ll bus or Uber if it’s raining.

Judy and Joe agree that they only need one car to get to the park-and-ride while commuting to work. Kim and Kyle realize that they don’t need their cars in order to get to work and could save a lot of money if they downsize to one or none, especially considering they pay for parking in their building. These instances illustrate the importance of considering location when deciding between owning a car and using rideshare. Likewise, your activity choices also play an important role.

Activities. Activities and hobbies dictate a huge portion of our lifestyle choices. Do you have kids or do your favorite activities involve a lot of driving? If you love the outdoors, could you still get to those hikes you’ve been dying to do without a car? Some recreational activities may be limited when you don’t own a car, so it’s important to consider this when determining if utilizing rideshare options is not only economical but also practical. Here are some of the activities Judy and Joe and Kim and Kyle participate in:

Judy and Joe’s weeknights are spent shuttling kids to and from various sports practices. Once home, they typically enjoy a homecooked meal together. On the weekends, the kids generally compete in sporting events. Occasionally, they also get out of town for a family camping trip in the mountains.

Kim and Kyle spend their weeknights going to the gym. This is often followed by dinner at a friend’s house or a local restaurant. During the weekend, they like to hike, visit Kim’s family on Bainbridge Island, and kayak as often as Seattle’s weather permits.

Judy and Joe agree they likely still need two cars to get the kids to their conflicting practices. They’ve decided to experiment by driving only one of their cars for a couple weeks in conjunction with ridesharing as needed to see if life with one car would work for them. Kim and Kyle agree that they still need one car for their weekend trips and for hauling their kayaks around town. As we can see, our activity choices are also an important consideration in deciding whether to own a car or use rideshare.

Bottom line. Having a car for the sake of convenience may unnecessarily be costing you money. Using rideshare might save you money; however, it may be more practical for you to own a car if you’d like to maintain a certain lifestyle. We encourage you to evaluate your situation.

If you’d like to speak with a financial advisor about your current transportation situation, we can help you determine if it makes more sense for you to own a car or utilize the various rideshare options available today. Please reach out to us. We are here to help you!

 

Sources: 

*https://bettermoneyhabits.bankofamerica.com/en/auto/cost-of-owning-a-car

** https://www.zipcar.com/pricing

***https://www.ridester.com/uber-rates-cost/

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

Demystifying Retirement Income

Demystifying Retirement Income

 

You’ve worked hard. You’ve saved your pennies and watched every cent. Yet now that retirement is just around the corner, you’re second guessing whether you’re truly ready.

We see this often at Merriman. Near-retirees get cold feet not because they’re unprepared for retirement but because they’re unsure how to manage their retirement income. There’s less room for mistakes without a salary coming in. At the same time, retirement is full of financial uncertainties, ranging from personal health to the economy.

The solution isn’t to delay the retirement you’ve worked hard to secure. If you want to feel financially secure heading into retirement, start by learning the ins and outs of your retirement income.

 

How Much Income Do You Need in Retirement?

Outliving your savings is a top fear for retirees. Rather than letting worry consume you, do the math to understand your retirement budget. Account for major budget items like housing, transportation, and healthcare along with variable expenses. Then, take stock of your retirement benefits to see how they stack up.

Is there a big gap? Consider how you can reduce living expenses in retirement. Housing is a major expense, and many older adults are paying for more housing than they need. Downsizing saves money and cashes out home equity to put towards retirement savings. However, this only works if you have enough equity to make selling worthwhile. To estimate home equity, subtract the mortgage balance from the home’s current market value.

After housing, recurring bills and lifestyle expenses have the biggest impact. Rather than assuming small expenses don’t make a dent, use a budget to see how it all adds up and then adjust as needed.

 

Understanding Retirement Income Sources

Now that you understand the expenses side of the equation, let’s examine retirement income.

 

How to calculate Social Security benefits

Social Security retirement income depends on two main factors: lifetime earnings and the age you claim benefits. Filing early reduces benefits whereas delaying past full retirement age increases Social Security payments. Estimate your Social Security benefits online.

 

What about pensions?

Workers with a pension enjoy a second fixed income source in retirement. Pension plans distribute monthly payments according to a vesting schedule. Making the most of a pension requires understanding minimum distributions, age requirements, and other fine print to maximize your payout.

 

Other fixed income sources in retirement

In addition to Social Security and pension plans, retirees rely on fixed-income investments for income generation and capital preservation.

Fixed income investments include:

  • Bonds and bond funds
  • Certificates of deposit
  • Fixed annuities
  • Mortgage-backed securities
  • Preferred stock or securities

 

How to Supplement Fixed Retirement Income

Fixed-income sources provide stability and peace of mind. They don’t, however, keep up with rising costs of living. To maintain their standard of living over time, retirees need diversified income.

 

Building a balanced investment portfolio

It’s standard for near-retirees to shift asset allocation towards low-risk investments. However, stocks are still an essential part of a balanced portfolio due to the return potential. An experienced financial advisor can determine the right asset allocation for your goals. They’ll also develop a withdrawal strategy to maximize retirement savings. Common approaches include the 4% withdrawal rule, fixed-dollar withdrawals, fixed-percentage withdrawals, systematic withdrawal plans, and withdrawal “buckets.”

 

Working in retirement

Many older adults are starting businesses for flexible retirement income. The best businesses for retirees are low-risk and low-cost, such as consulting in a field where you have niche experience. Beyond less financial risk, consulting businesses are easy to start: Simply file a “doing business as,” also known as a DBA, with the Washington Secretary of State to operate as a sole proprietor under your brand.

 

Retirement shouldn’t feel like the great unknown. If you feel like you’re walking into retirement without a plan, contact Merriman to learn how we can help. Merriman’s fee-only services will help you clarify your retirement goals and understand your options for achieving them. Contact us toll-free at 800-423-4893 or email info@merriman.com to learn how you can invest wisely and live fully.

 

 

 

Written exclusively for Merriman.com by Katie Conroy.
Katie Conroy is the creator of Advice Mine. She enjoys writing about lifestyle topics and created the website to share advice she has learned through experience, education and research.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.

Saving for College? Here are 5 Accounts You Can Start Using Now

Saving for College? Here are 5 Accounts You Can Start Using Now

 

It’s true what people say about having kids: the days are long, but the years are short. Sometimes our busy, ever-changing lives leave us wondering: “Where did the time go?” When it’s time to send your child off to college, you may feel sentimental, but there’s no need to feel unprepared. With so many options to save for your child’s future, you’ll be able to find the one for you.

 

Invest in a 529 Plan

When saving for your child’s future, 529 Plans are a popular choice. These savings accounts offer tax advantages similar to a Roth IRA. When your child is ready to go to college, you can make tax-free withdrawals to pay for qualified education expenses.

Benefits

  • You can open a 529 plan as soon as your child is born. This allows the money to grow over a longer period of time.
  • The funds apply to both undergraduate and graduate programs at any two- or four-year institution.
  • They allow up to $300,000 in lifetime contributions.
  • If your child doesn’t go to college, you can change the beneficiary.
  • Some K–12 expenses may qualify under the 529 plan, such as tuition and fees.

Drawbacks

  • Any funds not spent on qualifying expenses are subject to income tax and a 10% tax penalty.
  • You are required to report withdrawals on the FAFSA if the account is owned by someone other than the parent. This could negatively impact the student’s eligibility for financial aid.

 

Consider a Roth IRA

Roth IRAs are typically used for retirement savings, but you can also use them to save for your child’s future. You can’t take distributions on Roth IRAs penalty free before 59½. However, any account open for at least five years can be used for education, so make sure you open the account no later than your child’s 8th grade year.

Benefits

  • Distributions are tax free and penalty free as long as they are used for qualifying education expenses.
  • After graduation, the account can still be repurposed as your retirement account.
  • The value of the retirement account is not included in a FAFSA application.

Drawbacks

  • Roth IRAs have annual contribution limits of $6,000. An average year at a university can cost upwards of $20,000. So, it would be difficult to save enough money with a Roth IRA account unless you start early.
  • Remember, any withdrawals from a Roth IRA are considered income, which will be reported on a future FAFSA. This might impact your child’s chances for financial aid.

 

 

Coverdell ESA

A Coverdell Education Savings Account (ESA) is a great alternative to a 529 plan. It is a tax-deferred trust account with high potential for growth.

Benefits

  • Savings can be used for primary and secondary education as well as college.
  • There is more flexibility in what is considered a “qualifying expense.” Parents can use the funds to pay for school uniforms, tutoring, and other K–12 programs.

Drawbacks

  • Annual contribution limits are set at $2,000 per person, per year.
  • You also cannot make contributions after age 18. All funds must be spent before the beneficiary turns 30.
  • There are also income limits on who can contribute to a Coverdell ESA account.

 

 

Custodial UGMA/UTMA

Custodial accounts are another great way to save for your child’s future. With a Custodial UGMA/UTMA, you have the ability to transfer assets to your minor children and enjoy tax breaks.

Benefits

  • When the assets are transferred, a portion of the value of the assets is taxed at the child’s tax rate, and the rest is taxed at the parent’s tax rate.
  • Since this is only a transfer of assets, there are no restrictions on how the money should be spent, other than the benefit of the child.
  • A custodial account allows any asset (not just cash), such as stocks, bonds, art, and real estate, to be transferred to a minor.

Drawbacks

  • Since the assets are owned by the child, parents have less control over how the money is spent.
  • These accounts will have to be reported on a FAFSA, so there is a chance for them to negatively impact financial aid.

 

Savings Bonds

Savings bonds are issued by the US government and can be purchased from a financial broker or directly from the US Treasury. They may be a good option for more conservative investors, at least for a portion of your investment strategy.

Benefits

  • Bonds are low-/no-risk investments since they are backed by the federal government.
  • If you invest in Series EE or Series I bonds, interest earned is tax free when funds are used for qualified education expenses.

Drawbacks

  • Incredibly low rate of return. You’ll need a backup savings plan.

 

When it comes to financial planning, you’ll also want to consider making sure you have your retirement accounts set up first. A certified financial planner will help you decide which account is the best option when saving for your child’s future. He or she can monitor all of your accounts and suggest any changes needed to secure a bright financial future for you and your family.

 

 

 

 

Written Exclusively for Merriman.com by Lyle Solomon

Lyle Solomon has considerable litigation experience as well as substantial hands-on knowledge and expertise in legal analysis and writing. Since 2003, he has been a member of the State Bar of California. In 1998, he graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, and now serves as a principal attorney for the Oak View Law Group in Los Altos, California.

 

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and it is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. .  Facts presented have been obtained from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.

Why Diversification Matters

Why Diversification Matters

 

 

You’ve probably heard the saying, “Don’t put all your eggs in one basket,” but what exactly does that mean for retirement planning? Or, put a different way: Why should you care about diversifying your investments?

 

I’ve had a number of conversations lately with my clients who have a concentrated portfolio (sometimes through no fault of their own), and thankfully the past decade has rewarded many of them. Either because of how they’re compensated (i.e., RSUs) or through a laid-back approach to rebalancing, I’ve seen a lot of portfolios with a large allocation to one or a handful of stocks. Mostly, it’s been a concentration in tech stocks (e.g., AMZN, MSFT, GOOG, FB, SNAP, TSLA, etc.), but because of how the recent bull market has been a success story for many large growth companies, I’ve seen lots of different variations all with a common theme: A lot of eggs, all in one basket.

 

First, we need to understand the importance of diversification. Building a portfolio with lots of different types of investments spreads the risk around. Technically speaking, to have a well-diversified portfolio means you have different assets that are as uncorrelated to each other as possible. It’s not necessarily a quantity-over-quality metric. You can easily have a portfolio made up of dozens or hundreds of different stocks/mutual funds/ETFs and still be undiversified if all of those investments behave very similarly. Proper diversification can be achieved by investing in asset classes that are made up of different types of investments (stocks, bonds, real estate, commodities, cash, etc.), by investing in the same type of investment (small-sized company stock vs large-sized company stock), and by investing in different geographic regions (US vs International). Obviously, this is a high-level overview, and there’s a lot of research and effort that goes into building a thoughtfully diversified portfolio.

 

Now, back to why you should care. There’s another famous saying that goes something like this: Wealth can be built with concentration, but it should be protected with diversification. A realistic investment philosophy should be built with planning at its core. I often tell my clients (or anyone that will listen) that it’s impossible to predict what’s going to happen in the market, but we can prepare for the unexpected.

 

“While we can’t predict the markets, we can prepare for them.”

 

If you’ve built up a concentrated portfolio and because of that concentrated allocation you’re closer to retirement than you might have been otherwise: Congrats! I’m not here to chastise anyone for successfully building their wealth. Instead, I’d be remiss if I didn’t ask: What’s next? Or better put: What’s your plan to protect your hard-earned wealth? This is where diversification can make a huge impact on your future retirement plans. A well-constructed and professionally managed portfolio should be able to weather the ups and the downs of different market cycles. It’s very important that I point out that a diversified portfolio is in no way immune to losses, but with the right amount of guidance and discipline, diversification can be the key to long lasting financial freedom.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

Beware of the Tax Cost of Turning Your Primary House into a Rental Property

Beware of the Tax Cost of Turning Your Primary House into a Rental Property

 

Since the financial downturn and real estate crisis in 2007–09, residential real estate in many parts of the country has seen a significant increase in value. This increase has created additional considerations for homeowners deciding if they want to sell an existing property or convert it into a rental.

 

Rental properties are taxed differently than personal residences. In some cases, these can make it tempting to move into an existing rental property for a few years to reduce the taxable income on the sale.

 

Homeowners also need to be mindful of the reverse—how the decision to turn a primary house into a rental property can be a poor tax move.

 

Tax Benefits When Selling Your Personal Residence

 

Since 1997, homeowners have been able to use the Section 121 exclusion to exclude up to $250,000 of gains from taxation ($500,000 if married filing jointly) upon the sale of a property. In order to qualify, the taxpayer must own and use the property as a primary residence for two of the past five years. Notably, these two years do not have to be the most recent two years. A taxpayer could live in a property from 2017–2019 then sell the property in 2021 and still qualify.

 

Example 1: Jolene and Max purchased their house in June 2011 for $400,000. They sell in June 2021 for $850,000. Because their total gain is less than $500,000, none of that gain needs to be reported as taxable income when they sell their property.

 

Example 2: Luke and Jenny purchased their home in June 2011 for $400,000. They sell in June 2021 for $1,050,000. Because their gain is $650,000, they will need to include the $150,000 above the $500,000 exclusion in their income. This $150,000 will be taxed at long-term capital gains rates. (NOTE: If Luke and Jenny did significant renovations, those costs can potentially be added to the $400,000 purchase price, reducing the taxable income.)

 

Understanding the Tax Impact of Turning Your Primary House into a Rental Property

 

When deciding to move into a new house, homeowners often have two options for their existing property: they can sell it or turn it into a rental property. While turning a primary residence can offer the appeal of receiving monthly rental income, turning your house into a rental property can have a significant tax hit come tax time if you decide to sell.

 

Example 3: Jolene and Max from Example 1 decide in June 2021 to turn their house into a rental property rather than sell. After 2 years, they decide they would rather not be landlords and sell the property in June 2023 for $850,000. Because they lived in the house as their primary residence for at least two of the last five years, they still qualify for the Section 121 exclusion. In fact, because the rental period happened after they lived in the house as their primary residence, they don’t even need to prorate the gain between periods of qualifying and non-qualifying use as they would if they moved back into the rental property. The only income to be reported is the recapture of any depreciation that was taken during the rental period.

 

Example 4: Jolene and Max from Example 1 decide in June 2021 to turn their house into a rental property rather than sell. In this case, they keep it as a rental property for four years before selling the property in June 2025 for $850,000.

When they sell their house in June 2025, it was only used as a personal residence for one of the past five years. They no longer qualify for the Section 121 exclusion. The entire $450,000 gain will be included in their taxable income. They will also have to recapture any depreciation that was taken during the rental period.

 

Jolene and Max’s decision in Example 4 to rent their house for four years before selling it has resulted in a significantly higher tax bill than they would have had if they sold it immediately or if they had sold it after only a few years of renting out the property.

 

Planning Opportunities for Real Estate that Was Converted into a Rental Property

 

There are several planning opportunities that owners might consider if they are in Jolene and Max’s situation described in example 4. These include:

 

  1. Moving back into the property to re-gain the exclusion
  2. Continue renting out the property until qualifying for a step-up in cost basis
  3. Consider a Section 1031 exchange into a different rental property
  4. Sell the principal residence and purchase a different rental property

 

Move Back into the Property to Re-Gain the Exclusion

 

Individuals can move back into the rental property to regain some of the exclusion.

 

Example 5: Tina and Troy purchased their house in June 2011 for $400,000. They turned it into a rental property in June 2015. In June 2019, they want to sell the house. Because it was a rental property for the past four years, all gains will be included in taxable income.

They decide to move back into their house in June 2019 and sell it in June 2021 for $850,000. They now qualify for the Section 121 exclusion because it was their primary house for at least two of the last five years.

 

When they sell their house in 2021, it had six years of qualified use as a personal residence and four years of non-qualified use as a rental property. The $450,000 of gains will be prorated between $450,000 x 60% = $270,000 that can be excluded and $450,000 x 40% = $180,000 that cannot be excluded.

 

Also, all depreciation that was taken during the four years as a rental property will be included in taxable income when the house is sold.

 

By moving back into their rental property for two years, Tina and Troy were able to exclude some, but not all, of the gains from the years they owned the property.

 

Continue Renting Out the Property Until Qualifying for a Step-Up in Cost Basis

 

Currently, when the owner of an asset dies, that asset gets a complete step-up in cost basis. Any gains that might otherwise have been included in taxable income are erased, and the cost basis is “reset” as if the taxpayer purchased the asset on the date of death.

 

Example 6: Tina and Troy from Example 5 don’t move back into the house in 2019, but they instead continue to rent it out. They live in Washington, and Troy is in bad health. Troy dies in June 2021 when the rental house is worth $850,000.

 

Tina receives a complete step-up in cost basis. It is now treated as if she purchased the house for $850,000. If she sells the house for $850,000, there is no taxable income, regardless of whether it is a personal or a rental property.

 

The example above assumes Troy and Tina live in a community property state like Washington (or California, Texas, or several others). If they live in a common law state, they likely would not receive the full step-up in cost basis described. Also, owners of rental properties receive a step-up in any depreciation taken in addition to the capital gains, providing an even more powerful tax benefit.

 

Consider a Section 1031 Exchange into a Different Rental Property

 

If a taxpayer no longer wants to rent out their current property, but they are willing to have a rental property, they can defer taxes with a Section 1031 exchange into a new rental property. The taxpayer can sell one rental property, purchase a new rental property, and transfer the cost basis. This will delay any taxes until the new rental is ultimately sold.

 

This 1031 exchange is a complicated process that requires working with a broker who specializes in it. This exchange can only be done with rental properties. It cannot be used to turn a rental property into a new primary house.

 

Sell the Principal Residence and Purchase a Different Rental Property

 

The final strategy to consider is to sidestep the issue altogether. If the taxpayer is moving out of a principal house and wants to own a rental property, it may be more tax efficient to sell the principal residence then purchase a different rental property.

 

By selling the principal residence before turning it into a rental property, the taxpayer can exclude all gains up to the $250,000 or $500,000 maximum of the Section 121 exclusion. Then the new rental property can be purchased and managed with a “reset” higher cost basis.

 

Conclusion

 

When moving out of a house, it may be tempting to turn that house into a rental property. There may be benefits to receiving increased cashflow that a rental can provide.

 

However, if you have a property with significant appreciation, consider carefully any decision to rent it out when you leave. This decision to rent out the property may give up far more in tax benefits than are received in new rental income.

 

If you’d like to understand the right approach for you, contact the Merriman team to strategize the decision to rent or sell your property while remaining mindful of the big picture.

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.