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Leslie Bonacum
847-267-7153
mediahelp@cch.com
Neil Allen
847-267-2179
neil.allen@wolterskluwer.com

In Real Estate, CCH Says Biggest Tax Breaks Are Closest To Home

(RIVERWOODS, ILL., February 7, 2003) Ė While many investors have seen their stocks struggle to maintain value over the last few years, many homeowners have seen their property appreciate nicely, thanks in part to low interest rates that make mortgages very affordable. Investing in real estate also can bring special tax advantages, according to CCH INCORPORATED (CCH), a leading provider of tax law information. But, the biggest benefits lie closest to home. Taxpayers who enter into rental real estate investments find a much more mixed tax outlook.

The biggest tax benefit from real estate lies in the ability to exclude a large amount of gain from income on the sale of a personal residence. Married homeowners who meet certain simple conditions can exclude $500,000 in gains on the sale of their homes from their incomes. Single taxpayers who meet the requirements can exclude $250,000.

Although this has been the law for five years now, many homeowners are not aware of its details and its implications, according to John W. Roth, JD, federal tax analyst for CCH.

"Being able to exclude a large gain entirely from your income is an enormous benefit," Roth said. "It not only means the income from the sale isnít taxed, but the exclusion also makes it easier to qualify for certain itemized deductions and various credits and other tax breaks."

If a married couple found the right bargain each time, they could make a half-million dollar profit every two years by buying and selling their personal residence and not pay any tax on it.

"The family home is the largest asset owned by many families, and a profitable sale of a long-time family residence is often a key to financing retirement," Roth noted.

Requirements for Exclusion

To be eligible for the exclusion, a taxpayer must have owned and occupied the home for two years out of the five years leading up to the sale. The periods of ownership and use donít have to overlap and they donít have to be continuous. You could occupy the home for the first and last years during the five-year period, for example, and still qualify. The exclusion cannot be used more often than once every two years.

If someone becomes incapacitated but has lived in his home for one year during the five years before the sale, he also can count time he spent in a licensed facility for the purpose of meeting the two-year test.

Widows and widowers can claim the full $500,000 exemption (versus the individual filerís $250,000) if they sell the home in the same year that their spouse dies. If the surviving spouse chooses to hold onto the home, the cost basis of the residence is increased to the value it has at the time of his or her spouseís death. For example, a couple purchases the home for $100,000 in 1988. In 2000, one spouse dies, and itís determined the house is worth $150,000. The cost basis of the residence will be $150,000 when the survivor sells the home at a future date.

One Home at a Time

The exclusion applies only to a principal residence, but with a little time and a little planning, a couple with two homes might be able to use the exclusion for both, Roth points out.

"Suppose a couple owns a principal residence in Chicago and a winter home in Florida. In June of 2002, they sell their Chicago home, realizing less than $500,000 in gains and paying no tax on the sale," Roth said. "After living most of the time in their Florida home for the next two years, they decide to move to an apartment, rather than maintaining their single-family residence. In August of 2004, they sell the Florida home for $300,000, again excluded from income."

A short-term or seasonal absence does not disqualify a home as a principal residence. Itís also important to note that something other than the traditional single-family home can qualify. Thus, a houseboat, mobile home, cooperative apartment or condominium that you own may be your principal home.

Few Downsides

In addition to the exclusion, homeowners usually qualify to reduce their tax bill by itemized deductions for the mortgage interest and property taxes they pay. With so many pluses, itís hard to see the disadvantages to home ownership, but in fact there are a few.

One is that property taxes are one of the preference items that can subject you to the alternative minimum tax, or AMT. Also, some home-related interest thatís deductible for regular tax purposes is not deductible for AMT purposes. Itís unlikely, however, that a homeowner would pay more tax due to the AMT than a renter with otherwise similar finances would. Another difficulty arises if you have to sell a home for a loss. The loss is considered personal, and non-deductible, under the tax code.

Deductions for Itemizers

There are additional tax breaks available to homeowners in a position to itemize deductions, although in some cases, taking them may increase exposure to the alternative minimum tax. Mortgage interest is deductible on mortgages of up to $1 million dollars for the homeownerís residence and a second home. In the case of a second home, though, the homeowner must either not rent it out or live in it personally for at least 14 days a year or 10 percent of the days it is rented at a fair market value Ė whichever is greater.

Homeowners also can deduct the interest on home equity loans of up to $100,000 or the difference between the balance of their mortgage and the fair market value of their homes, whichever is less.

Home equity loans can expose borrowers to the AMT, however. Home equity loans used for anything other than home improvements are not deductible in the calculations used to arrive at the income figure used in determining AMT liability.

"The mere fact that you have a home equity loan doesnít automatically mean that youíll owe the alternative tax, but it does mean you probably should do the AMT calculations to make sure," said Roth.

"Points" paid at financings or refinancings canít be deducted all at once, but instead are deducted over the life of the loan. But if a loan on which points were paid is refinanced, all of the remaining amount becomes deductible.

Homeowners also can take their state and local property taxes as itemized deductions, but these also can trigger AMT liability, since they are not deductible in figuring potential AMT liability. Ordinarily, you canít deduct the cost of repairs to your home or take any deduction for depreciation, utilities or the cost of insurance. The rules change, however, if you use a portion of your home as a home office. Then, the portion of those expenses attributed to the office space can be deducted as a business expense.

There is a catch, however, if you later sell your home. Any depreciation you took must be must be subtracted from the exemption amount and it will be taxed at a rate of 25 percent.

This provision requires homeowners to do a bit more homework to decide whether the home-office deduction is worth it, given the tax theyíll have to pay when they sell their home.

Getting Started as a Landlord

If you approach real estate as a source of income and a road to riches, there are various tax benefits and pitfalls Ė especially for those who are not full-time real estate professionals. You might start out by renting your home Ė or a summer home Ė for part of the year. You can rent out a personal residence for up to 14 days a year and not have to count the rent as income, although you canít also take any deductions in connection with the rental.

"If you own a suitable home in a popular vacation spot, or near a big sports or convention venue, you can rake in a substantial amount each year without paying taxes on it," Roth noted.

At the other extreme, you can rent out a second home and treat it fully as rental real estate, with the deductions related to it, as long as you limit your "personal use" of the home to less than 15 days a year, or 10 percent of the days you rent it out, whichever is greater.

In between these two extremes, you can deduct a portion of expenses for mortgage interest, taxes, utilities, maintenance and so on from the rental income. Then, a portion of the interest and taxes Ė but not the other expenses Ė can be taken as ordinary itemized deductions. The IRS and the Tax Court have different ways of figuring how you split deductions between the rental activity and itemizing, though.

"The Tax Court formula is more generous to the property owner, but you might have to actually go to Tax Court to defend its use," Roth noted. "This is one area where Iíd strongly encourage people to consult a tax professional."

Full-time Rentals Bring Bigger Breaks

Greater deductions are available if property is rented full-time. If you actively manage the property you can offset up to $25,000 in losses from the rental activity against your regular income. But the $25,000 maximum is reduced by 50 percent of the amount of your adjusted gross income over $100,000. So if your adjusted gross income is $150,000 or more, you canít offset any other income with your rental losses. If you donít meet the "active participation" standard, your losses are limited to the amount of income you receive from the rental activity.

As a landlord, you have to keep careful records, separating things such as repairs from improvements that increase your "basis" Ė the amount you have invested in the property.

When you sell a rental property you have to reduce your basis in the property by the amount of depreciation youíve taken. Then, in addition to taxes on any remaining long- or short-term capital gains, you pay 25 percent on the amount gain equal to the depreciation taken.

Like-kind Exchanges Defer Tax

If you want to trade up from one rental property to another without paying tax, you may be able to arrange for a "like-kind exchange." This typically would involve designating a new rental property of equal or greater value within 45 days of selling the old one and then completing the sale within 180 days of disposing of the old one.

Ordinarily, a like-kind exchange simply postpones the day when a property owner has to face the tax consequences of a sale. Sooner or later, he or she may simply no longer be up to the constant attention demanded by broken pipes and defaulting tenants.

A relatively new development, though, allows for a partial like-kind exchange, in which an owner can sell a property and then purchase a part-interest in a property largely owned and managed by others.

"But this is a developing area, and the advice of a professional is highly desirable," Roth said.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients.. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.

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