Below are the some of the tax advantages of purchasing either a principal residence or an investment property.
The information below should be used for educational purposes only and it is not a complete list nor may it apply to your situation or circumstance. You should consult with your tax advisor to find out the tax ramification of the transaction that pertains to you.
If you have any questions or need information on any of the items below, please do not hesitate to call David Silkman, CPA, MST, Broker at 310.478.9200 x301 or email him at david@SilkRoadRealtyInc.com.
What is Deductible?
The most common questions asked are: "How much will I save on my personal taxes if I purchase a home?" and "What items are deductible?".
The answer is that when you purchase a personal residence, whether a house, condo, townhouse, mobile home or a houseboat, the following items are tax deductible:
Now let’s look at an example. Assume your monthly mortgage interest payment, property taxes and PMI are $4,000 per month. Assuming you are in a 35% federal and state personal marginal tax brackets, your combined monthly federal and state tax savings is $1,400 ($4000 x 35%). Another way to look at it is that your monthly housing expense is only $2,600 ($4,000 - $1,400).
Therefore, you should always compare your monthly rent expense to your net monthly home expense (after tax savings) to determine how much more it will cost you owning a home. To use our calculator to compare renting versus owning, please click here.
If you are interested in purchasing a rental property and would like to calculate your rate of return and other investment ratios, please click here.
To download a brochure on this topic, please click here.
$250,000 or $500,000 Gain Exclusion
You can exclude the first $250,000, or $500,000 if you are married, of your gain from the sale of your principle residence if you have owned and used the property as your principal residence 2 out of the preceding 5 years that ends on the date of the sale or exchange.
Therefore, you can purchase a new property every 2 years and qualify for the gain exclusion. Other items to note:
Example - Assume you and your spouse purchase your principal residence nine years ago for $500,000. You have always lived in it. If you sell it this year for $900,000, the $400,000 gain is federal and state tax free. You will not pay a penny of tax on the $400,000 gain.
For a brochure on the different taxes and tax brackets, please click here.
Renting Your Home for Less Than 14 Days a Year is Tax Free!
If you rent your personal residence for less than 14 days per year, the total amount of rent you receive is tax free! This is a great tax loop hole, especially in Los Angeles where all the studios are. You may be able to rent your place to them for less than 14 days per year and not have to pay taxes on the income.
Home Energy Tax Credits
Two expanded home energy credits are available to help homeowners lower both their winter heating bills as well as their tax bill, the IRS is reminding taxpayers. The nonbusiness energy property credit and the resident energy efficiency property credit can both be claimed by eligible homeowners when filing their federal income tax return. The credits are available when you itemize your deductions or take the standard deduction.
By spending as little as $5,000 before the end of the year on eligible energy-saving improvements, a homeowner can save as much as $1,500 on his or her 2009 federal income tax return. Due to limits based on tax liability, other credits claimed by a particular taxpayer and other factors, actual tax savings will vary.
Not all energy-efficient improvements qualify for these tax credits. For that reason, homeowners should check the manufacturer’s tax credit certification statement before purchasing or installing any of these improvements. The certification statement can usually be found on the manufacturer’s website or with the product packaging. Normally, a homeowner can rely on this certification. The IRS cautions that the manufacturer’s certification is different from the Department of Energy’s Energy Star label, and not all Energy Star labeled products qualify for the tax credits.
Eligible homeowners can claim both of these credits when they file their 2010 federal income tax return. Because these are credits, not deductions, they increase a taxpayer’s refund or reduce the tax he or she owes. An eligible taxpayer can claim these credits, regardless of whether he or she itemizes deductions.
Home Office Deduction
Generally, a self-employed individual will qualify for a home office deduction if the office is a place where the taxpayer meets with customers, patients or clients, or is used on an exclusive and regular basis for administrative or management activities of his or her trade or business, and there is no other fixed location of the business where the taxpayer conducts substantial administrative or management activities of the business. Even if a taxpayer conducts administrative activities at a fixed location outside the home, he or she is still eligible to claim a deduction as long as the administrative activities conducted at the outside location aren't substantial. Space in the home used to store inventory for a wholesale or retail business also qualifies as business use of the home.
Deductible home office expenses fall under two basic categories: direct and indirect expenses. Expenses that are directly attributable to the home office, such as painting the office, repairs to the office space, etc., are 100% deductible to the business. The second category is indirect expenses that are attributable to the entire home, for which only a fraction of the total amount is allocated to the home. These include home mortgage interest, property taxes, insurance, certain utilities, property taxes, homeowners association dues, gardener, pool service and depreciation. If the home is rented, substitute rent paid for interest, taxes and depreciation. The fraction used to allocate business portions of the indirect expenses is determined by dividing the business use square footage by the total square footage of the home.
Example - Assume you are self-employed and you work out of your home. The total square footage or your home is 1,000 sq. ft. You have a room that is dedicated and used exclusively as an office and it is 200 sq. ft. Therefore, 20% (200/1,000) of all your home expenses including depreciation are tax deductible. And, it does not matter whether you own or rent.
The home office deduction is, however, limited to the gross income of the business derived from the use of the home for that business, and where the gross income is less than the expenses, certain expenses can be carried forward for the same trade or business in the subsequent years but cannot be used against a positive income from another business. Carryover never includes home interest, taxes and casualty losses because they are allowed without regard to the gross income limitation.
If the self-employed taxpayer owns the home, there is a negative aspect to the home office deduction that can create unexpected consequences when the home is sold. First, the allowable home office depreciation is never excludable under the $250,000 ($500,000 for joint filers) exclusion of gain for primary residences and will end up being recaptured as taxable income upon sale. But, the current maximum tax rate on the recapture is only 25%. Furthermore, if the office is located in a separate structure, then the home sale is treated as two sales, the sale of the home portion and a sale of the office portion. Any gain from the office portion would not qualify for the home gain exclusion and would be taxable.
Example - A married couple sells a home that includes a home office in a separate structure that is 20% of the total home square footage. The home, originally costing $150,000, is sold for $500,000. If the home office had never been claimed, or if the office had not been in a separate structure, the entire home gain, except recaptured depreciation, could be excluded from income. However, in this case, $70,000 (20% of the gain) becomes taxable income. (For this example, to keep it simple, we haven't taken into account improvements, selling costs, or depreciation.)
Home Modifications for Disabilities
Generally, home improvements are not deductible except to offset home gain when the home is sold. But a medical expense deduction may be claimed when it is a medically-necessary home modification. The modification expense is deductible as a medical expense to the extent it exceeds any resulting increase in the value of the property.
The full cost of certain improvements can be included as medical expenses, because they are considered not to increase the home's value. Examples of these types of modifications include constructing entrance or exit ramps for the home; widening entrance/exit doorways, hallways and interior doorways; installing railings and support bars; and lowering or modifying kitchen cabinets. Note, however, that medical expenses can be claimed only to the extent that they exceed 7.5% of the taxpayer's adjusted gross income (AGI) (10% if taxed by the AMT).
Active Real Estate Participant
If you own at least 10% of a rental and have substantial involvement in managing the rental, then you are considered an active participant and you can write-off up to $25,000 of the loss generated from that rental activity against your other incomes such as wages or interest income. However, your modified adjusted gross income cannot be more than $150,000. The $25,000 loss is reduced if your modified adjusted gross income is more than $100,000 and completely disallowed if its more than $150,000.
Substantial involvement in managing means that you make management decisions such as who to rent it to or which repair service company to call. Easy to qualify for.
Example - Assume you work for X Company as an employee. Your salary is $90,000 a year. You also own a rental property that generates a tax loss of $20,000 per year. You would be able to write-off the $20,000 rental loss against your wages of $90,000 and pay taxes on the net amount of $70,000.
Furthermore, it is possible to have a real estate investment that show a tax loss but has positive cash flow. In certain situations and if planned correctly, the depreciation expense may cause the property to show a tax loss while it actually has positive cash flow. Depreciation expense is a tax expense not an actual out of pocket expenditure.
Passive Activity Rules
When you own real estate, it is considered a passive activity unless you qualify under the Active Real Estate Participant rule discussed above or as a Real Estate Professional discussed below.
Passive activity losses can only be offset against passive activities that have income.
Now lets look at an example. Assume you are an investor in rental partnership that reports a tax loss and you are an investor in an internet company that reports income and in both investments are passive activities to you. You would be able to offset the loss from the rental activity against the income from the internet activity. You would pay taxes on the net amount if positive. If the net amount was negative, the loss was more than the income, then the excess loss would be carried over to the following year and would be used to offset future incomes from the passive activities. Basically, you do not lose the loss. It gets carried over to future years until it is all used up or when the asset is sold.
Real Estate Professional
If you qualify as a real estate professional, then the Passive Activity rule above will not apply to you and you will be able to write-off your real estate losses, no matter the amount, against all of your other sources of income such as wages, interest, capital gains and etc.
To qualify as a real estate professional, you have to meet the following two requirements:
Material Participation - To meet the material participation tests in items 1 and 2 above, you can elect to combine all interest in rental real estate and treat them as one. Otherwise, you would have to prove tests 1 and 2 above for each property separately.
Real Property Trade or Businesses - Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage is considered a real property trade or business.
Tax Tips - As long as one spouse meets the above tests, then the he or she is considered a real estate professional and can use the loss to offset against the other spouse's non-real estate incomes such as wages, interest, business or capital gains.
Tax Tips - To prove that you are a real estate professional, you should keep a detail log through out the year to document your hours and involvement in your real estate activities. Without proper documentation, it will be difficult for you to prove your status as a real estate professional if every questioned or audited by the Internal Revenue Service.
Example - Assume the one spouse is a doctor and the other one a real estate professional. If the spouse that is a real estate professional has a loss for the year, she or he can offset that loss against the other spouse's medical income. Works great!
Qualified Principal Residence Trust
No asset is more important to shield from creditor claims than the house you live in. For most of us, the house represents the bulk of our fortune. It may also have great sentimental value.
The personal residence trust is the most commonly used structure to protect a home. This is a structure that is inexpensive to set up, simple, and exceptionally effective. They have never failed to achieve their desired objective. Let us take a look at how these trusts work.
A personal residence trust is an irrevocable trust. The word "irrevocable" scares many people. None of us want to do anything that is irrevocable, especially when we are talking about our most significant asset.
Fortunately, irrevocable simply means that no one (like a plaintiff or a creditor) would be able to force you to revoke the trust. You will always be able to do so, and quite easily, without going to court. For example, under California law there is an easy procedure to revoke an irrevocable trust that just requires the trustee of the trust and the beneficiary to sign a simple document.
Because the trust is irrevocable, the assets owned by the trust are not owned by you. At least not in the legal, technical sense. The trust now owns your home. Because you no longer hold legal title to the house you live in, it is not an asset that your creditor can reach. Your legal relationship with the house you live in becomes the same as your legal relationship to the Transamerica building in San Francisco. It is not your asset, and when you get sued, your creditor cannot attach either one.
The residence trust allows you to continue living in the house, rent free, usually for the rest of your life (technically, this period of time is measured in a specified number of years tied to your life expectancy). Your children or other family members would then become the beneficiaries of the trust. This structure is very similar to your living trust.
There are no income tax consequences on the transfer of the house into the residence trust. There are no property tax consequences and no property tax reassessment. Your bank cannot accelerate the mortgage (there is a federal statute that prevents the bank from doing anything with your mortgage when the ownership of the house is transferred to a trust).
Because the trustee of the trust will be a person you appoint (usually a friend or family member, but never you), you will retain the ability to sell the house or to refinance the house. Additional flexibility can be built into the trust to accommodate your specific needs.
The trust is not subject to any annual fees or filing requirements. Once it is done it is done.
To summarize, the residence trust is an inexpensive, easy to establish structure that allows you to continue living in your house, allows you to retain control over your house, but at the same time makes it unreachable to creditors (which has been tested in practice time and time again). It is no wonder that these trusts are our favorite asset protection technique for a personal residence.
Living Trust - What Is It And How It Could Help You
A trust is an arrangement under which one person, called a trustee, holds legal title to property for another person, called a beneficiary. You can be the trustee of your own living trust, keeping full control over all property held in trust.
A "living trust" (also called an "inter vivos" trust) is simply a trust you create while you're alive, rather than one that is created at your death. Different kinds of living trusts can help you avoid probate, reduce estate taxes, or set up long-term property management.
Most people want to leave as much of their money to their children, or other heirs, as possible -- and want to avoid a big chunk of that money going to probate lawyers. That's where living trusts come in -- they can eliminate the need for probate and probate fees.
Probate involves inventorying and appraising the property, paying debts and taxes,
The two most common types of living trusts are:
Unless you expect to owe federal estate tax at your death or your spouse's, a basic living trust to avoid probate is probably all the trust you need.
For a brochure on estate taxes and tax brackets, please click here.