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
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
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
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
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.
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,"
"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,
"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
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
"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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