Whole Ball of Tax 2003
IN REAL ESTATE, BIGGEST TAX BREAKS ARE CLOSEST TO
HOME
(RIVERWOODS, ILL., January 2003) – While many investors have seen
their stocks and mutual funds 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 and software. 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 isn’t taxed, but the exclusion also makes it
easier to qualify for certain itemized deductions and various credits
and other tax breaks."
For married people, the $500,000 exclusion applies as long as a few
simple tests are met and neither one has used the exclusion in the
last two years.
"The fact is, if they found the right bargain each time, a married
couple can make a half-million dollar profit every two years by buying
and selling their personal residence and not pay any tax on it,"
Roth said. "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."
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 don’t have to overlap and
they don’t 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 (such as a nursing home) for the purpose
of meeting the two-year test.
Widows and widowers can claim the full $500,000 exemption (versus
the individual filer’s $250,000) if they sell the home in the same
year that their spouse dies.
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. It’s 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, it’s 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 that’s deductible for regular tax purposes is not deductible
for AMT purposes. It’s 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.
"This might be one situation in which you wish you had invested
your down payment in the stock market instead," Roth said. "You
can at least write off some of your losses if you make a bad investment
there."
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 homeowner’s 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 – 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 doesn’t automatically
mean that you’ll owe the alternative tax, but it does mean you probably
should do the AMT calculations to make sure," said Roth. "There’s
a worksheet in the Form 1040 instructions to help you determine if
you need to file Form 6561 for the AMT."
"Points" paid at financings or refinancings can’t be deducted
all at once, but instead are deducted over the life of the loan. For
example, $6,000 in points paid to obtain a 20-year mortgage would
lead to an interest deduction of $300 per year. 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 liability for the
alternative minimum tax, since they are not deductible in figuring
potential AMT liability. Ordinarily, you can’t 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 they’ll have to pay when they
go to sell their home," said Roth. "That’s after they make
sure that they meet all the requirements for taking the home office
deduction in the first place."
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 – especially for those
who are not full-time real estate professionals – to be considered.
You might start out by renting your home – or a summer home – 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 can’t 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 – but
not the other expenses – 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 I’d 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 – by screening tenants, arranging
for repairs and so on – 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 can’t offset any other income with your rental losses. If you
don’t 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"
– 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 you’ve 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.
"The rules for like-kind exchanges are complicated, and mistakes
that disqualify a transaction from like-kind treatment can be very
costly, so it’s best to make sure you get and follow competent advice
if you want to use this technique," Roth warns.
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.
"This is potentially a good solution for someone who wants to
retain a stream of income based on real estate, while leaving the
bothers of ownership largely to others," Roth said. "But
this is a developing area, and the advice of a professional who’s
up to date on the the law and the latest IRS rulings is highly desirable."
About CCH INCORPORATED
CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded
in 1913 and has served four generations of business professionals
and their clients. The company produces more than 700 electronic and
print products for the tax, legal, securities, insurance, human resources,
health care and small business markets. CCH is a wholly owned subsidiary
of Wolters Kluwer North America. The CCH web site can be accessed
at cch.com. The CCH
tax and accounting destination site can be accessed at tax.cchgroup.com.
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