
Dear hosts, I know that a lot of you are just starting out on your journey of Airbnb hosting; and the last thing you’re thinking is of selling or expanding your empire. It's 2020 and life happens, at the beginning of the year, I didn’t think I'd be selling, but here I am which is one of the reasons for today's episode. In today’s episode, we’re going to discuss “How to Defer Your Capital Gains Taxes When You Sell Your Short Term Rental.”
Are you scratching your head yet? Let’s start at the beginning, you bought your home or vacation rental, you started renting on Airbnb or VRBO. Now you want to sell because your property has appreciated in value. Yay.
It means you have to pay taxes on that capital gain. Boo.
Depending on your market, those taxes can be as high as 35% of your gain. Double boo.
If you want to buy another investment property and turn it into a vacation rental or diversify your portfolio into long-term tenants, you can defer that capital gain with a 1031 exchange. Mind you I say defer—not completely forget.
Who is Bill Exeter?
There are tons of rules and regulations, which is the reason I brought in Bill Exeter, Chief Executive Officer of Exeter 1031 Exchange. Bill has been doing exchanges for 0ver 36 years and has administered over 100,000 of them throughout his career. His company is one of the few qualified intermediaries that have any kind of government oversight.
In How to Defer Your Capital Gains Taxes When You Sell Your short term rental, you’ll learn the importance of this and much more. We’ll answer questions like:
- What is a 1031 exchange?
- Which rules and regulations do I need to follow when doing a 1031 exchange?
- The dates that I have to hit (Trust me – that one is important — you miss them and you have to pay those capital gain taxes.)
- Can I do a 1031 exchange if I also live in my home? (Yes, we answer that question.)
- And finally, how do I protect myself and my funds?
Whether you’re thinking about selling now or in the near future, How to Defer Your Capital Gains Taxes When You Sell Your short term rental is the episode that will answer all your big questions — even the ones you didn’t know you had.
Evelyn: I know my people are talking about it and we're going to start. And before this, I'm going to do the introduction about how much you have done on 10:31 exchanges. So you and I don't have to talk about it. So let's talk about what is a 10:31 exchange and you know, how can someone that is selling an Airbnb? Like, let's start the story with the beginning.
Bill: Sure! What probably a perfect example is you have someone who buys one property and they get into the Airbnb business and they really like it. And they get to the point where they think, “Okay, it's time to sell this one and maybe buy two or three” and increase the number of units that they have and increase their cash flow. And then they often meet with their CPA, or at least hopefully they meet with their CPA. And that's when the CPA tells them how much taxes they're going to pay. And that's usually a shock. And then once they get past that, they realize, hopefully the CPA so it tells them, “You can do a 10:31 exchange to defer all the taxes”. So going back to the one property, they bought it and it's gone up in value. Now we have this capital gain and they've depreciated. So we have depreciation taken on the unit and they're going to sell it. The capital gain and the depreciation is deferred into the future by doing a 10:31 exchange. And that means that they're going to reinvest in other in rental or investment or business-use property. So in this case more Airbnbs and probably two or three or four units instead of one. So they're diversifying into multiple units and maybe even the different geographic areas, etc, all on a tax-deferred basis. So it's really designed to allow them to sell, do a 10:31 exchange, keep all of the money in their pockets. So instead of paying federal and state taxes, everything is in maintains their investment in their pockets so they can buy more units, etc, and not lose half or a third of their profit to the government.
Evelyn: Yeah! Because the reality is to house depending on the state where you live and all of this. And, and I want to be very clear. We're not giving you any advice right now. This is not this show. You need to talk to your CPA. All right, this is informational. This is very informational. And a lot of this, one of the reasons why I've decided to do this episode is because I am going through a 10:31 exchange. That's how what I'm doing when I'm selling my house in New York. And what I want my people to know is this —- if you're selling your primary residence, if it's your home, you cannot a 10:31 exchange because you're doing it, it your primary residence. But, if are doing, (which is something that I'm doing) my primary residence also has an Airbnb. It also has an investment part in it. I can do that investment part can be deferred as a 10:31 but my primary residence does not have to be, it cannot be deferred. So I have to pay capital gains taxes on that other part. So I want to be clear about that because you know, people might think like, “Oh, but I can do that with”, because a lot of people do their primary residence as Airbnb.
Bill: Absolutely, NO! The primary residence portion falls under section 121 of the tax code or what we call the 121 exclusion. So f they're single, they get 250,000 in capital gain tax free. Or if they're married 500,000 in gain tax free, as long as they've lived in it for two out of the last five years. So that would apply just to the primary residence portion of the property.
Evelyn: Yes. And are there any criteria for the investment portfolio part?
Bill: Yeah, that's a good question! That we get a lot of that. It's what we call split use property because parts that part of your primary residence part is of investment property. And a lot of people get really hung up on how long has it been used as a rental investment or business use in this case, Airbnb. And you know, the code and the regs have no holding period required. And that's where people get so confused because one person says “you have to hold it for at least a year”. And another person says “a year and a day” and somebody else say “two years”. And then people call us and say, “I don't get it. What is it?” And then the real issue is you have to prove that you had the intent to hold for rental purposes. So if you get audited, can you show that, you know, X percent of your property was used as an Airbnb, and that was truly your intent? Well, usually if you've used it as an Airbnb, you've got plenty of records and documentation and rental income, etc. So you can prove that that was your intent. So there's really no holding period required. It's all about what was your intent? What did you actually do with the property? And obviously the longer you hold it as an Airbnb, the easier it is to prove that was your intent. So that's where the timing comes in, but the timing is not a requirement. It just helps prove the facts.
Evelyn: Yeah. And so, and in my case, I've been doing 10 years of Airbnb and it's reported in my taxes as well. And so our old expenses and everything else.
Bill: Yeah and 10 years is fantastic. I mean, we're usually say if we've got a year and it's a plain vanilla transaction, you're okay. If you're pushing the envelope a little bit, or if it's a split use property two years might be good, but 10 years is you're in great shape.
Evelyn: Yeah. I mean, And dear host think about like, let's say for example, you might have a two family home, or you might have a casita in the back that you're using as your Airbnb and you have the primary residence. If you sell your home, you could take that primary… that gain for yourself — that $250,000 if you're single and the $500,000, if you're married. But then if you're going to buy another property for investment now for primary residence for investment only, then you could use part of that and defer the capital gains taxes. And what I do want you guys to think about is not that those capital gains taxes will ever go away, right? Bill?
Bill: Correct! They're just deferred as a tax deferred exchange, not tax-free.
Evelyn: Okay. Will that ever change? Can that get deferment ever changed to be tax-free like, if you hold onto that property, let's say for two years, and then moved into it. If it was a, let's say a vacation rental for two years, and then you decided to retire there and moving, can it become your primary residence?
Bill: Good point! Yes! It can be a yet be carefully. The initial intent has to be to hold for rental purposes, but intent can always change. So if you rent it and hold it as an Airbnb for say two years, which will straddle three tax returns, that's really strong proof. That was your intent. So after that, you could certainly change your intent and move into it as a primary. The other thing to keep in mind is — if you let's say you don't convert it to a primary residence, you just exchange it. You hold it as an Airbnb and you keep exchanging and maybe keep expanding the number of Airbnb units you've got, etc. When you pass on and you leave the, all of your real estate holdings to let's say your kids or your grandkids, or whoever you choose to leave the property to, at that point, they generally will get a step up in cost basis. That means that the capital gain tax goes away, the depreciation recapture tax goes away. So it's tax deferred throughout your lifetime. But if you hold it until you pass your errors, we'll get that step up in cost basis. And that's when it becomes tax-free.
Evelyn: Really? So it will be tax free too. But then don't, they have to pay taxes for your, Oh my God, what is it called? Do death taxes?
Bill: I believe it's a state tax? Yeah, death taxes. So, the reason you get that step up is let's say you bought a one Airbnb for a hundred thousand, and then, over the years it went up in value now it's worth 500,000. And you pass on the, the heirs that inherit that property, their cost basis is stepped up or increased to the fair market value at the date of death. So if it's worth 500,000 at death, their cost basis is increased to 500,000 and reason for that is what you just pointed out. And that is the value of that property. — the 500,000 is included inside their estate for estate tax or death tax purposes. So they can't double tax you, they can't tax you on a state tax and capital gain tax. And most of us will never pay a state tax unless you're, well, at least under current tax law, you know, you've got like $24 million in value. And unless your estate exceeds that, you'll be fine as a couple. You won't pay any estate tax and then you also get the step up in cost basis. so becomes tax-free.
Evelyn: Okay. Alright! And I'm going to say one more time, guys. You have to find some good CPAs, some good accountants, because this is so important for your planning, your estate planning.
Bill: Very true!
Evelyn: Yeah… You have to know.
Bill: It's amazing that there's a lot of CPAs, you know, they specialize so you need to find a CPA that really specializes in real estate and that real estate tax related items. Cause a lot of them, don't focus on real estate and real estate is a very specialized industry.
Evelyn: Yeah, yeah. Believe me. I'm in the moment right now researching finding me a new CPA because, my last one had passed away a couple of years back and whatever. And it's a task, and not a fun one. Okay! Let's continue… because there are very specific rules, let's say. So you have your vacation rental that you're selling that you have decided, “You know, I just want to sell this is it… I am moving to another state and I like managing my properties close to the chest. So I want to move those properties there, nd I'm going to do a 10:31 exchange”. Let's talk about all the rules and regulations because they are many of them.
Bill: True! The real key ones are really kind of three or four. One is you have to have the 10:31 exchange in place before you close on your transaction. So as long as you've got the 10:31 in place and the qualified intermediary lined up and all of the documentation has been completed and ready to go before closing, then you're in great shape. If the closing occurs without the 10:31 exchange in place, unfortunately it's taxable and there's no way to go back and fix that. So always make sure that the 10:31 is in place before closing. And then you've got some timeframes as you pointed out to worry about. So when the closing occurs and the closing is what triggers the timeframes, so if you close today, let's say tomorrow's day number one. And you've got exactly 45 calendar days to identify what you're going to acquire. That's the most stressful part of the 10:31 exchange. Because 45 days is about six weekends. It moves very quickly…
Evelyn: Yeah, Especially…
Bill: After that 45 day window. Oh, I am sorry, go ahead.
Evelyn: Oh, I'm sorry. Especially in a market, like right now, the properties are on the market and they're selling in a day. It's like, “You don't have time to be like dilly dallying, like….
Bill: Yeah, that is very, very, very quick. And a couple of facts there too. You know, a folks will call us and ask, “Well, can I buy first? If I find the right property, then buy first?” And you certainly can! It's a reverse 10:31 exchange. Those are a lot more complicated and more costly. And if there's a lender involved, they don't really like reverse exchanges. But there's a couple of ways to approach it when you're selling your current property. If you can find a buyer who's willing to give you a long-term close, maybe 90 days, 120 days or more, or if they'll give you, you know, a number of 30 day options to extend, as long as you haven't closed your deadlines don't start running…
Evelyn: So…
Bill: Sorry, go ahead…
Evelyn: No. Well, okay. And I'm sorry, Bill to interrupt, because right now I'm in the middle of my closing.Bbut I feel like, look, I don't have the money to put a down payment on anything else. Right?
Bill: Right!
Evelyn: And the reality is that for me, it's like properties that are available will not be available when I close. They will be gone.
Bill: That's true. That's very true! And that's one of the risks cause you identify, most people use the three property rules, so they identified three properties. And historically, the reason for that is you identify three, probably with the intent to buy one. And then the second and third are backup. And as you pointed out in today's market, the second, third property are properly long gone. So the backup strategy doesn't work anymore.
Evelyn: And what happens if you have to buy more than one, because you have a big capital gain.
Bill: Good question! So there's a couple of ways to do it. Some people will sell one property and buy one property. That's a larger property. So maybe they sell one unit and buy a fourplex. So it's a one for one, others may sell one property and want to buy a whole bunch smaller assets. You know, like a client I talked to me yesterday was selling here in California, buying in Tennessee. And on a tennessee, he was buying a whole bunch of single families at 20, 30, $40,000 a pop. So in that case, you're going to use the 200% roll. So you can identify as many properties as you want up to two times or 200% of what you sold. So if you sold for million? 200%, it would be 2 million. You could identify $2 million worth of property. And he identified all a lot of single families. So that makes it more challenging. But that's one way to do it. If you want to diversify your portfolio is to use the 200% rule and buy a lot of smaller assets.
Evelyn: Yeah, exactly! So it's not…. Oh, and then another thing is this, please let them know that if you're selling your short term rental, it's not like you have to buy another short-term rental. It could be that you could buy a multi-family. Right?
Bill: True! Absolutely!
Evelyn: Like it doesn't have to be a just short-term rental or you could buy a single family that you're going to rent out to a long-term tenant. You just have to be incline, right?
Bill: Exactly! That's a good point because a lot of people interpret like kind property as condo for condo or Airbnb for Airbnb. And that is not true. You're exactly right! Like kind literally means you're selling real estate. You have to buy real estate. You just have to re-invest in other real estate. And as long as it's some type of rental investment or business use, it will qualify for qualified use and light kind treatment. So it's wide open, including things like water rights and air rights and mineral rights, oil and gas interests. Those are also considered to be real estate and you can exchange into, or out of those as well. So there's, it's a very broad definition.
Evelyn: Yeah. I think, and the law just changed not that long ago, right? Because there were other, they made it a little tighter.
Bill: They did. Yeah. The tax reform act of 2017, eliminated non real estate. So before that you can do 10:31 exchanges on real property, but you could also do it on anything else. Like, chipping trucking, machinery, equipment, livestock, etc. The tax reform Act eliminated anything that was not real estate. So now you can only 10 31 exchange real estate to real estate.
Evelyn: Really? So, let's say if you… I thought that it was just like, it could be… like could they do 10:31 exchanges for incline? Like, let's say if I'm selling, you know, cows, can I buy another kind of animal?
Bill: Yeah. Typically you could, we did a lot of exchanges on different herds so cattle and what have you. Typically it would be something like, it would be cows, maybe Jersey made as the breed and they would go to a Holstein or something like that. So it'd be a herd for a herd. It does have to be very specific when it terms of non real estate. So light kind was very specific. We would do a lot of aircraft exchanges, things like that. We did a lot of the large trucks, a lot of shipping boats and vessels, things like that, but that was all eliminated. So now it's just real estate for real estate.
Evelyn: So all of that was eliminated. Oh, they must be so pissed!
Bill: Yeah, it was, it was kind of a frustrating process. There was three or four exchange companies that did nothing but personal property. They didn't do real estate. So they obviously had a very difficult transition because they, everything they just did were just wiped out. We were 99 point, but a basically 99.9% real estate. So it didn't really affect us.
Evelyn: Okay…All right. So I'm sorry. Let's go back to the rules of time because that's really important. So we have the first 45 days. So we have 45 days.
Evelyn: Yes! Now, and what happens because I imagine it must have been happened if those properties that you identified go “bye-bye”, and you cannot buy any of them.
Evelyn: Yeah. Like, like it could be held. Like, it doesn't mean that you… I don't know. Tell me, tell me, talk to me, bill. I'm concerned.
Bill: It is. It's very very scary!
Evelyn: Okay, you are just like scaring me. Alright! So what else? So we need to make sure that whoever we're dealing with… I mean, and how do we find them? Because my person was recommendation from my lawyer.
Evelyn: Wow. You see, I would have never thought about that. Isn't that amazing?
Bill: That was a lot of information fast.
Bill: Yep. You've probably written off, more than half of it. So it's a, it'll be a big bite.
Evelyn: In 16 years. I've had like a zillion accountants.
Evelyn: Okay. So do I have to just go back to my taxes? Will it be in there?
Bill: True! You just don't want to pay too much in taxes. It's a painful experience.
Evelyn: It's okay or joyful. It depends… It depends… You know, and especially like, look, in my case, I'm not selling because it was my choice. It was more because the city, um, decided to, to do certain things with Airbnb and they just banned us all of this the regular rules and regulations just were against us. So Michelle, that for me was like between that and COVID and everything else, it just wasn't worth it. It wasn't worth it to continue doing it. And there's a lot of equity in the house. Anything else that a person should know or should ask?
Bill: I think, probably the one thing we haven't covered would be kind of qualified use and we've kind of touched upon it, which is it has to be rental investment or business use, but you get folks who also intend to buy property, fix it up and then sell it or flip it. And you get folks who are developers, they buy, they build these sell. So if, the investor is really in the business to buy and then build or rehab or convert, and then sell? They're really holding for sale, they're not holding for investment. So it doesn't qualify for 10:31 exchange treatment. So it really needs to be someone who intends to buy and then do anything where they buy and hold, buy, and develop, buy and rehab, etc. But they, whatever they do after they're done doing it, they hold it as rental property or investment or business use. And then I qualify it. So it's all about the intent to hold for investment, as opposed to the intent to hold for sale.
Bill: It's true!
I understand that all this new information can be overwhelming and a bit daunting, but we need to be informed so we make the best decisions for our business and life.
fantastic episode! learned a lot about a very confusing subject. thank you, as always evelyn!