Considerations When Selling Real Estate – Selling A Second Home or Rental Property

Speakers: Jon Gay, Bruce Hosler, & Jason Hosler

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Jon Gay (00:07):

Welcome back to Protecting & Preserving Wealth, I’m Jon Jag Gay. I am joined as always by Bruce Hosler and Jason Hosler of Hosler Wealth Management. Pleasure to be with both of you today.

Bruce Hosler (00:14):

Jon, great to be with you.

Jason Hosler (00:15):

Good to see you, Jon.

Jon Gay (00:17):

So, last time we began our conversation, considerations when selling real estate, and we talked about selling your principal residence. We ran a little bit long, so we’re making this into a second part here. Today, we’re going to talk about selling a second home and a rental property. Bruce, where do you want to start?

Bruce Hosler (00:32):

So, let’s just talk about a second home and the definition of what that is. So, I’m a perfect example, so I’m going to use myself as an example. Laura and I have two homes, we have one in Prescott and we have one in Scottsdale. One of those homes is our primary residence or principal residence and the second one is a second home.

And people sometimes get confused, well, what’s my primary home? What determines my primary home? What determines my secondary home? Let’s just talk about that for a second, Jason. What are some of the rules that the IRS looks at to determine your primary residence versus a secondary home?

Jason Hosler (01:15):

Well, the first thing they’re looking at is where did you spend the majority of the year? So, when we’re helping people determine a primary residence, a principal residence, you’re looking, have you lived there over six months of the year and then how do you prove that you live there over six months of the year?

Well, they look at a number of things. It can be where do you have your driver’s license? Where were the water bills coming in? Where are you getting your mail?

Bruce Hosler (01:41):

Well, time out. Let’s just clarify: the address on your driver’s license.

Jason Hosler (01:44):

Right. That’s an important detail to get in there. So, there’s a number of factors that you can use to establish your primary residence and the time that you spent there.

Bruce Hosler (01:58):

So, if you have a secondary home, what I want to talk about that is, everyone seems to know about the section 121. We talked about that in the last episode, which is, if you’re single, you can exclude capital gains of $250,000. If you’re a married couple, you can exclude up to $500,000 of capital gains on your primary residence, if you’ve lived in it and owned it for two years of the last five years. Well, on a secondary home, there is no section 121; it is not available.

Jason Hosler (02:33):

You just have to recognize those capital gains or losses whichever way you have it when you go to sell it; you don’t get any kind of exclusion from the tax code for a secondary home.

Bruce Hosler (02:44):

Now, unlike what we’re going to talk about later as a residential rental home, you can take depreciation on that, but on a secondary home, you don’t get to take any depreciation. So, when you sell it, you don’t have to worry about recapturing that depreciation having taxable income either. So, no depreciation, no recapture coming back on that. Now Jason, let’s go over this again, what is included in cost basis on a second home?

Jason Hosler (03:13):

It’s going to be very similar to your primary residence. So, of course, the money that you use to purchase the home, your purchase price, then any improvements that you make to the property, putting in a pool, a new roof. But repairs and maintenance, of course, are not included in your basis.

Bruce Hosler (03:31):

Okay. Now, we want to take advantage of the tax code with our second home. And the advantages of a second home when you sell it is that you get treatment as long-term or short-term capital gains as opposed to ordinary income.

Talk about that a little bit, Jason. Long-term capital gains, what are the tax rates? What are the two tax rates we have for long-term capital gains and how long do you have to own that second home to qualify for long-term capital gains versus short-term?

Jason Hosler (04:06):

Well, you have to own the home for more than a year. So, a year and a day to qualify for that long-term capital gain. I think most of our clients and people that we work with generally don’t own their second homes for less than a year. But you could come into a scenario where maybe you bought it and then you said, “You know what, this actually isn’t right for us,” and turn around and sell it in less than a year.

Bruce Hosler (04:27):

Or there could be health changes or the kids could move and grandma wants to be close to those grand babies, man, I mean, I see that happen. Like the kids are moving, we’re going there, we want to be close to those grandkids and senior sports.

Jon Gay (04:40):

Life Happens.

Jason Hosler (04:41):

So, that short-term capital gain rate though, is taxed at your ordinary income rate. So, whatever your other income is, whatever bracket that gets you to, you’re going to be paying most likely more than the long-term capital gains rate.

So, if you can wait to get that sale for the long-term capital gains over a year and a day, that’s going to be good for you because depending on your other income, you could potentially even have a 0% long-term capital gains rate. Most likely it’ll be the 15% rate and that goes up to just around $600,000 in capital gain in your income and then above that is the 20% rate. So, those are favorable tax rates.

Bruce Hosler (05:21):

So, let’s just cover that for a second. The 0% long-term capital gains rate, if you’re married, filing joint folks is around $96,700 in 2025. So, if you keep your income below that, that capital gain could be zero.

Jon Gay (05:39):

That’s your AGI on your tax return, correct? That you’re talking about.

Bruce Hosler (05:41):

That is the taxable income not the AGI. So, taxable income.

Jason Hosler (05:46):

So, that’s after your deductions have come off.

Bruce Hosler (05:48):

So, you could be making $120k, $130k and still qualify for a zero capital gains rate.

Jason Hosler (05:53):

That’s right.

Jon Gay (05:54):

Got it. Okay.

Bruce Hosler (05:55):

Now the other thing that we run into is the long-term capital gains rate. Bruce, what’s the difference between a 15% and a 20%? And the issue is how much money do you have as taxable income if you make too much money on the capital gain?

So, you have your regular income, let’s say you have a nine to five job, and you make a hundred thousand, but then you got $500,000 in a capital gains, you sold your second home, that puts you over $600,000 and for a married couple, that’s the number married filing joint long-term $600,050.

If you’re over that now you trigger a 20% long-term capital gains rate. So, we’re trying to keep our people in that long-term 15% rate if we can, that’s worth 5% right there if we can strategize it that way.

Jason Hosler (06:42):

And for our clients who are doing Roth conversions and have been in the process of moving to tax free, you can see how important having tax free assets are if you’re trying to control your taxability in any given year, especially if you have a real estate transaction happening that year.

If you can keep your other income lower that year, maybe you’re a few years into doing Roth conversions, you hold off on a Roth conversion that year, you take some income from the Roth to keep your income down, you sell your property, you can get more favorable tax rate by managing that appropriately.

Jon Gay (07:15):

I love that we’re having this conversation because this is something we’ve talked about, in it seems almost every episode of the podcast, but the planning piece of it. It’s not just talking to a CPA and looking at what happened in the last year and doing your taxes, the planning, the looking forward, the realizing that this is really just a complicated jigsaw puzzle with a bunch of different pieces, how those pieces interact with each other to create those numbers at the end of the day to minimize your tax burden.

Bruce Hosler (07:39):

And here’s a prime example. If we have been successful in getting someone to the 0% tax bracket, social security’s not taxed, all their other income is life insurance retirement plans or Roth IRAs or anything like that, they don’t have any taxable income and they have a second home and they sell it and let’s say they make $180,000.

And let’s say we advise them wisely to say, “Hey, you know what, why don’t you sell that at the end of the year and do an installment sale and recognize half of that $180k in 2025 and the other $90,000, so $90,000, and $90,000 in 2026.”

Well, we just kept you underneath the limit and so now that capital gain is income tax free because the rest of your stuff is income tax free. So, we want to be strategic about trying to plan for these long-term capital gains.

Bruce Hosler (08:31):

Now the other thing we run into a lot, Jason and Jon, is people come in, they’re like, okay, you know, they haven’t caught up with all the tax law changes. You know, today, here we are on May 22nd and the big, beautiful bill was passed this morning in the House. I don’t know when the Senate’s going to pass it, maybe they will, maybe they won’t, but sounds like they probably will.

But the tax laws change. Well, a lot of clients come to us and they go, “Now if I take my second home and I sell it and I take the proceeds and put them in another home, then I don’t have to pay taxes, right?” And the answer is, “Is that available, Jason?”

Jason Hosler (09:05):

No, not on a second home. Unfortunately, and a lot of people do have that misconception that their vacation home or their second home, that they can sell it and then roll those proceeds over into another one that’s only available on investment properties if it’s your personal use, you cannot use section 1031.

Bruce Hosler (09:24):

Right. That’s a 1031 exchange. Only available now folks on real estate, used to be available on cars in that, but it’s only available on real estate by income property, whether it’s commercial or residential, it’s not available. So, if you take the proceeds, they’re taxable whether you roll them into a new house or you go to The Bahamas, whatever.

Jon Gay (09:43):

(Laughs) Well, this sets up a perfect segue. We’ve talked about selling your second home as a residence, now we’re talking about selling a rental property, in the back half of the podcast today.

Bruce Hosler (09:52):

Let’s define what that is now. So, what is a rental property? Well, this is not your principal residence or your primary residence, and it’s a property that you’re renting out and you’re receiving income at fair market value.

So, people, if your kids are in it and you’re not having them (pay) full rent, you’re making some gifting, we want to work on that. You need to be renting at the fair market value. Now, how should they take title to this rental home, Jason? I want to start with that.

Jason Hosler (10:26):

Yeah. Generally, we’re advising our clients that they want to protect the rest of their portfolio, their nest egg, whatever else they have going on by setting up a firewall. That firewall is an LLC, a limited liability company that you have per property.

So, we have a number of clients of course we have multiple rentals. Our general recommendation is you have a single purpose LLC for each one of those rentals. Because if something happens, someone slips and falls, there’s a lawsuit, it’s limited to the property inside that LLC.

Bruce Hosler (11:09):

As far as the exposure for liability.

Jon Gay (11:11):

Yeah, if you had one LLC and owned six properties in it, something went wrong in one of the properties, they could come after all of it if it’s all in the same LLC, correct?

Bruce Hosler (11:20):

That is correct. And now we have some special rules, folks, here in Arizona. Arizona is one of nine states that is a community property state. The titling and the setting up of this LLC is we want it to be what’s called a disregarded entity.

Disregarded entity, that means the LLC does not file a tax return itself, it is just a legal entity to hold the real estate. Who owns the LLC? We want your revocable living trust to be the owner of that LLC. So, you have the property, the title is in the LLC. Who owns the LLC? Your trust.

And because you’re a married couple in Arizona or any other community property state, whether it’s California or Nevada, those are community property states, New Mexico, you get to disregard that LLC, it doesn’t have to file a return and so, it just reports on your personal return on the Schedule E as a rental property, very important.

But I’ll give you an example. So, Hosler Wealth Management has two offices. I happen to own both of those offices and I have a separate LLC for each office and that LLC is the holding company, but my trust owns those two LLCs.

Jon Gay (12:40):

Got it.

Bruce Hosler (12:41):

And so, that’s the way you should set it up, folks, if you have multiple rental properties or income properties.

Jason Hosler (12:48):

The other thing you want to think about to protect yourself when you’re engaged in rental real estate, you want to have some liability insurance and you want to have an umbrella policy as well to cover anything that might happen that goes above and beyond your typical homeowner’s insurance. And we also recommend that you generally work with the same company that provides your homeowner’s insurance to get your umbrella policy.

Because you don’t want to have a coverage gap where your homeowner’s insurance covers you up to say, $750,000, but your umbrella policy starts at only a million dollars and goes up from there. Now you have a $250,000 gap in coverage that you could eat if something happens. So, you want to make sure that that is done with both the homeowner’s insurance and the umbrella policy in mind.

Jon Gay (13:36):

Great point.

Bruce Hosler (13:37):

Folks, when we’re talking about umbrella policies, I want to see you getting $2 million to $5 million. Nowadays you need higher limits; a million dollars is not enough. They’re not that much more expensive for the extra umbrella coverage that protects you personally for above your auto liability and your homeowners. If you have accidents, things like that, that umbrella becomes very important.

Now on these rental properties, let’s switch over a little bit. These properties have the benefit of depreciation and that allows you to offset some of the cost of that. Let’s say it’s residential, that house the value of the building, you can’t depreciate the land, but that depreciation deduction offsets the income.

And so, residential or real estate income is tax favored because you have this depreciation that’s offsetting the income. And there’s a specific term I want you to remember, it’s called allowed or allowable so if it was allowed this year, you have to take that depreciation.

Whether you take it or not when you go to sell it on the backend, if it was allowed, you have to recapture that depreciation. So, you want to make sure your tax accountant is capturing that depreciation and giving you the tax advantages in the year. Now, what about a 1031 exchange on a rental property, Jason?

Jason Hosler (15:00):

Well, you see this often with rental properties where you have a large capital gain and depreciation recapture that someone might want to avoid having to pay taxes on. Maybe they want to sell the property and go to another one or they have an opportunity to sell a property and they’re looking for somewhere to avoid the capital gains and find another property to buy.

Well, the 1031 exchange is a perfect way to defer recognizing those capital gains like property, again, for the rental real estate. And when you go into the new one, your cost basis carries over and so if you have, say, another decade in your new property, your original cost basis versus where the property value is at now, that unrecognized capital gain can get pretty high.

Bruce Hosler (15:51):

For that reason, a lot of people will tend to hold onto a property after a 1031 exchange so they can get the step up in basis. Assuming you’re in a community property state like Arizona, if either spouse dies, one spouse dies, other spouse gets a full step up on their half too.

So, their new cost basis is the fair market value as of the date of death, their surviving spouse can turn around and sell that property immediately and pay zero taxes. That is the tax-free move on real estate. Now, sometimes people want what we call mailbox money versus being a landlord-

Jason Hosler (16:26):

Or they don’t want to wait for that step up in basis either.

Bruce Hosler (16:29):

Right. They just don’t want to be hassling with it. So, sometimes they’ll look at what’s called a Delaware Statutory Trust. We can’t go into that a lot here on the podcast today, but if some of you have rental property, you’re like, “I’m tired of being a landlord.”

You may want to talk to us about doing a 1031 with a Delaware Statutory Trust where you can get mailbox money and you can avoid all the terrible Ts: taxes, tenants, toilets, and trash. You can just have passive income from your real estate and you’re not responsible for any of the management.

Jon Gay (17:00):

Those four Ts, we’ve come back to it once again. I do want to mention one thing here because I have a friend who is really into rental properties and he decided he wanted to buy a beach house that he wasn’t quite sure if it was going to be a second home for him and his family or if it was going to be a rental property.

And when he was going through the real estate process to purchase this home, the realtor said, “There are really specific rules about what’s a rental property versus what is a secondary home.” It goes back to a point from earlier in the conversation about how often you are there.

And the realtor told my friend that they have subpoenaed cell phone records, cell phone towers, to see how often you are in this place. If you are in this house yourself more than X amount, it’s a secondary home. So, you can’t try to game the system, you really have to make sure it’s one or the other and know what those limits are when you’re going in and buying a property like this.

Bruce Hosler (17:56):

That’s exactly right. Other things they’ll do is they’ll look at the water bill, like how many times you flushed the toilet if somebody’s there or not. So yeah, the IRS audits have actually gone to cell phone towers and water bills and things like that to prove whether you’re present or not. And that determines if it’s your primary residence or a secondary, you know, oh, well you’re not here because the water bill’s zero and you claim that you’re there that month, you can get shot down.

Jon Gay (18:23):

So, they can check both. They can check primary versus secondary and secondary versus rental to see if you are there or somebody else is there.

Bruce Hosler (18:30):

They can do that. And cell phone towers are a good example; they can tell where you’re at.

Jon Gay (18:35):

I wanted to bring that up before we wrapped up because you do not want to try to game the system when it comes to this stuff, for sure.

Jason Hosler (18:40):

That’s a good point.

Bruce Hosler (18:39):

Thanks Jon.

Jon Gay (18:41):

Bruce, Jason, if our listeners want to come talk to you about any of the stuff we talked about today or anything related to their finances, how do they best find you at Hosler Wealth Management?

Bruce Hosler (18:49):

Jason, if you’re in Prescott, how should they get ahold of you?

Jason Hosler (18:52):

Give us a call at the office here (928) 778-7666.

Bruce Hosler (18:58):

Hey, if you’re in Scottsdale, folks, you can reach us on the website at hoslerwm.com, or you can call the office at (480) 994-7342.

Jon Gay (19:09):

Jason, the way you gave that phone number, you may have a second career as a nighttime soft rock DJ (laughs), so you delivered that very smooth. I just wanted to bring that up. Thanks guys. We’ll talk again in a couple weeks.

Bruce Hosler (19:17):

Thanks Jon.

Jason Hosler 19:18):

We’ll see you, Jon.

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Disclosure (19:23):

Investment advisory services are offered through Mutual Advisors, LLC DBA Hosler Wealth Management, a SEC registered investment adviser. Securities are offered through Mutual Securities, Inc., member FINRA/SIPC. Mutual Advisors, LLC and Mutual Securities, Inc. (collectively “Mutual Group”) are affiliated companies. Forward-looking commentary should not be misconstrued as investment or financial advice. The advisor associated with this podcast is not monitored for comments and any comments should be given directly to the office at the contact information specified.

Any tax advice contained in this communication, including any attachments, is not intended or written to be used and cannot be used for the purpose of 1) avoiding federal or state tax penalties,  2) promoting marketing or recommending to another party any transaction or matter addressed herein, and 3) Tax preparation and accounting services are offered independently through Hosler Wealth Management Tax Services. Any tax advice provided by tax professionals under Hosler Wealth Management Tax Services is separate and unrelated to any advisory or security services offered through Mutual Group. The accuracy, completeness, and timeliness of the information contained in this podcast cannot be guaranteed. Mutual Group does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation. Accordingly, Hosler Wealth Management does not warranty, guarantee or make any representations or assume any liability with regard to financial results based on the use of the information in this podcast.