What You Need To Know About...Real Estate Tax Advantages
Author: Lew Wessel
Is real estate a good investment right now? Damned if I know. What I do know is that the tax laws related to real estate investment and ownership, particularly the ownership and sale of a personal residence, are a smorgasbord of goodies for taxpayers. Here’s what you need to know:
Imagine, if you will, making $250,000 per year and paying no income taxes nor Social Security or Medicare on those earnings. Imagine not reporting this income to the IRS! Now you’re probably imagining how your family is going to survive during your long incarceration for tax evasion. No need. It’s all legal, thanks to Section 121 of the Internal Revenue Code which allows a married couple to exclude $500,000 of gain from the sale of a personal residence every two years. If the total gain is within that limit, the IRS does not even want you to bother them with submitting any form or paperwork showing the gain—it is, in tax-professional lingo: “non-reportable.” The requirement is simply that you and your spouse both reside in the residence for two out of the last five years and file a joint return. What exceptions there are to this general rule are, for the most part, attempts to help taxpayers who, through no fault of their own, do not meet the two-year rule.
It’s an amazingly generous statute and is the most obvious example of a whole basket full of tax incentives the Congress has developed in furtherance of the American dream of home ownership.
As fantastic as the Section 121 exclusion rule is, it only comes into play at the time of sale and, even then, only if there is an actual gain to exclude . On an ongoing basis, the most important tax “goody” for real estate is the deductibility of home mortgage interest. The “deductible” status of this expense should not be taken for granted; it is unique for a non-business or investment interest expense. The deductibility of interest on credit cards, auto loans and the like was eliminated by the Tax Reform Act of 1986. In addition, there is no similar deduction for renters of a personal residence.
You do need to be aware of certain limitations on the home mortgage interest deduction. First, the deduction is limited to interest on up to $1,000,000 of acquisition debt on a first or second home, or the refinancing (not including “cash-out” amounts) of that debt. In addition, the interest on an additional $100,000 in “home equity” indebtedness is deductible. Any interest paid on indebtedness over these amounts is nondeductible “personal interest.”
“Points” paid on an original mortgage are also normally deductible in the year of closing and even points paid on refinancing are deductible over the life of the new loan. Mortgage insurance payments, subject to income phase-outs, are also deductible for mortgages initiated from January 1, 2007.
One important thing to remember is that home mortgage interest is a tax deduction, not a tax credit, so the actual out-of-pocket savings to the taxpayer is the amount of the home mortgage interest paid times the marginal tax rate of the taxpayer. (Please see CH2, June, 2009, for an extended discussion of tax rates). Thus, for a taxpayer in the 25 percent marginal tax bracket who is trying to work through the rent vs. buy decision, the savings from paying $1,000 in interest versus $1,000 in rent is $250 (25 percent x $1,000).
Another tax advantage of home ownership, which is generally available to all taxpayers, is the deductibility of real estate taxes. Recently, with the passage of the Housing and Economic Recovery Act of 2008 (“HERA”), Congress turbo-charged this tax goody by allowing taxpayers to add up to $1,000 ($500 on a single taxpayer return) of this deduction to their standard deduction.
Another gift to taxpayers in HERA was the $7,500 first-time homebuyer’s “credit,” although, in reality, it was really just a tax-free 15-year loan from the IRS. This was upgraded to an actual $8,000 credit which has been very successful in many parts of the country in spurring home sales. Unfortunately, unless extended, it will expire on December 1, 2009.
The Mortgage Forgiveness Debt Relief Act of 2007 allows for an exception to the general tax rule that the amount of debt one has forgiven is recognized as taxable income. With this new statute, any discharge of debt up to $2,000,000 on a personal residence, due to the home’s decrease in market value, is excluded from taxable income. This was targeted specifically to the debt forgiven in “short sales.” Note that this exception only applies to a personal residence; it does not apply to credit card debt, or, with rare exception, to any other debt, unless the taxpayer is actually bankrupt or totally insolvent.
Home Equity Conversion Mortgages or “reverse mortgages,” available to homeowners age 62 and above, also deserve mention here since the IRS does not consider your monthly payouts from these financial instruments to be taxable income. The 2009 Stimulus Package increased the limit on these loans to $625,500, so they offer a truly potent tax-free cash flow alternative to home-owning “seniors.”
Other tax goodies are scattered throughout the Internal Revenue Code, some targeted to “green” home improvements, low-income housing, DC housing, and others. As with everything discussed in this article, I encourage you to consult your tax professional for further details.
Rental and vacation Homes
Here’s another tax fantasy for you: Tiger Woods finally relents and decides to play in the Verizon Heritage in 2010. You own the premier home in Sea Pines and agree to rent it to him for $25,000 for the week, while you jet off to Paris to get away from the crowds. Guess what? That $25,000 if totally tax-free! In fact, any income from rental of a dwelling for less than 15 days is excluded from taxable gross income (Code section 280A).
Once you rent a vacation home for more than two weeks, you become subject to the very complicated vacation home rental rules. This is a topic worthy of its own dedicated article in the future. For now, what you need to know is that, subject to the limits discussed above, all the interest and taxes related to the vacation rental home are deductible as either rental property or second home deductions, and any expenses related to the rental income, such as advertising, cleaning, or even a portion of utilities and insurance, reduce your reportable income. In addition, a portion of the cost of the property can be deducted each year as a “depreciation” expense. If you actually end up with a net loss from the rental, subject to income phase-out rules, you can deduct up to $25,000 from your taxable income! This is one of the few “tax-shelters” that survived the Tax Reform Act of 1986.
A very important tax issue you need to be aware of if you do get involved in rental real estate or real estate investments is what’s known as a “tax-free exchange” or a “1031 Exchange,” the latter named after the operating tax code section. “1031s” are very complicated and have to be done exactly right (I mean this!), but to simplify: The essence of the transaction is that a taxpayer can sell a real estate investment at a profit and then reinvest the entire proceeds in another real estate investment without recognizing any gain. This can be done over and over so that, in theory, a taxpayer could die without ever paying a cent of income taxes on millions of dollars of gain. You can only qualify for a 1031 if you plan for it BEFORE a sale, so, again, consult your tax professional.
Conclusion and caveats
There are unique and powerful tax advantages to investing in real estate. As a whole, these tax “goodies” don’t guarantee that real estate is a good investment, but they can reduce costs, shelter gains, and mitigate losses. In analyzing any real estate ownership or investment you, of course, need to include many other factors such as transaction costs on the buy and sell side, illiquidity, and the costs of ownership such as insurance, assessments, repairs, etc. Finally, it’s not possible in one general article to enumerate all of the traps that can negate your eligibility for a tax deduction or credit, nor is there an easy way to calculate how the alternative minimum tax (AMT) might affect many of the tax goodies above. In other words, and for the last time: consult your tax advisor!