A caption to a Wall Street Journal article from November 2016 read, “Home prices set a record in September (2016), reaching their highest level since 2006 and bringing to a close the worst stretch for the housing market since the Great Depression.” This caption may have seemed intuitive to many readers across the country, but to those in California it might have been surprising. After all, in the Bay Area, for example, some home prices pushed above 2006 levels as early as 2012. In some cases this rise in home prices has been substantial enough to change homeowners’ retirement plans.
When the recovery of California real estate as a whole began around 2012, the amount of equity in homes grew along with the rising home prices. As this equity grew, so did the number of options for how to use it. People could reduce expenses by downsizing with enough equity to buy a smaller home outright with cash. They could increase their living space by borrowing against the equity to pay for remodeling. The more adventurous could sell their California home and buy (or rent) a much bigger one in a different and less expensive state. In fact, selling a highly appreciated home to become a renter can liberate enough equity that early retirement becomes an option. The possibilities created by highly appreciated real estate are many.
Still, most homeowners never consider these possibilities. While homeowners love appreciation, they don’t love the tax liability it creates upon sale. However, real estate does receive some special tax treatment. Section 121 of the tax code allows those selling their homes to exclude $250k or $500k of capital gains depending on whether they are single or married. The problem, in the Bay Area anyway, is that even a $500k capital gains exclusion can fall short of offsetting all the gains.
For those interested in redeploying home equity into a rental property while avoiding capital gains altogether, there is the 1031 exchange. A 1031 exchange allows the exchange of one investment property for another while avoiding capital gains, as long as the exchange is done according to a very specific set of rules. Exchanges can be especially useful around retirement, when income streams become more appealing. It’s common for investors approaching retirement to shift some of their liquid investments from stocks to bonds. This essentially trades the appreciation of stocks for the income of bonds. A similar shift, from appreciation to income, is possible in real estate as well, through a 1031 exchange.
But a little patience is required for those interested in exchanging a home: 1031 exchanges are only for investment properties, and to establish a home as a legitimate investment property, the homeowners must move out of their home and rent it out for two years. Of course, moving out of their home also means they have to find a suitable place to rent for themselves. This search and adjusting to the idea of -renting can take time. After the two years of -renting out their home, the homeowners can begin the 1031 exchange process and, in some cases, still make use of the Section 121 capital gains exclusion of $250k or $500k. (In order to be Section 121 eligible, homeowners must have resided in their home for at least two out of the last five years.)
Not all homeowners are interested in leaving their current home no matter how much it has gone up in value. Many have deep roots in their community and want to leave their home to their children. But for others, a different home will better fit their current phase of life. In either case, if you live in California and own your own home, chances are that you have a lot of options, and that flexibility is something to celebrate.