How real estate can reduce your tax obligation
To maximize the tax benefits of property ownership, homeowners, investors and real estate professionals alike need to be aware of the breaks available to them as well as the rules and limits that apply. Whether you’re selling your principal residence, maintaining a home office or investing in rental properties, tax savings are available if you plan carefully. However, in some cases tax savings may be reduced under the Tax Cuts and Jobs Act (TCJA).
There are many tax benefits to home ownership — among them, various deductions. But when you file your 2017 tax return, the itemized deduction reduction could reduce your tax benefit from some of these breaks. And while that limit goes away for 2018, the TCJA reduces or eliminates these breaks:
Property tax deduction. For 2017, property tax generally is fully deductible under the itemized deduction for state and local taxes. For 2018 through 2025, however, the TCJA limits the deduction for state and local taxes to $10,000 for both property tax and either income or sales tax on a combined basis.
Mortgage interest deduction. For 2017, you generally can deduct (for both regular tax and AMT purposes) interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. For 2018 through 2025, the TCJA reduces the mortgage debt limit to $750,000 for debt incurred on or after Dec. 15, 2017.
Home equity debt interest deduction. For 2017, interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So if in 2017 you, say, use home equity debt to pay off credit cards or auto loans, for which interest isn’t deductible, you may be able to deduct the home equity interest on your 2017 return.
However, the TCJA eliminates this home equity interest deduction for 2018 through 2025. Depending on how you use the home equity debt, you might be able to deduct home equity debt interest as another type of interest expense, such as an investment interest expense.
If your home office is your principal place of business (or used substantially and
regularly to conduct business) and it’s the only use of the space, you may be able deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you may be able to take a deduction for the depreciation allocable to the portion of your home used for the office. You also may be able to deduct direct expenses, such as a business-only phone line and office supplies.
Or you may be able to use the simplified method for calculating the deduction. Under this method, you can deduct $5 per square foot for up to 300 square feet (maximum of $1,500 per year). Although you can’t depreciate the portion of your home that’s used as an office — as you could filing Form 8829 — you can claim allowable mortgage interest, property taxes and casualty losses in full as itemized deductions on Schedule A, without needing to apportion them between personal and business use of your home.
If you’re an employee, the business use of your home office must be for your employer’s benefit and your home office expenses are a miscellaneous itemized deduction. This means that, for 2017, you’ll enjoy a tax benefit only if your home office expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. Warning: Under the TCJA, for 2018 through 2025, miscellaneous itemized deductions subject to the 2% floor have been eliminated, including the home office deduction.
If you’re self-employed, you can use the deduction to offset your self-employment income and the 2% of AGI “floor” won’t apply. In addition, you'll still be able to deduct home office expenses for 2018 through 2025 (as long as you're otherwise eligible).
Of course, there are numerous exceptions and caveats. If this break might apply to you, discuss it with your tax advisor in more detail.
If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.
If you rent out your principal residence or second home for 15 days or more, you’ll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation. Exactly what you can deduct depends on whether the home is classified as rental property for tax purposes (based on the amount of personal vs. rental use):
Rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules. You can’t deduct any interest that’s attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction.
Nonrental property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an itemized deduction for the personal portion of both mortgage interest and property taxes, if the expense otherwise qualifies for the deduction. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property.
When you sell your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain if you meet certain tests. Gain that qualifies for the exclusion also will be excluded from the NIIT. To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by casualty losses and any depreciation that you may have claimed based on business use.
Warning: Gain on the sale of a principal residence generally isn’t excluded from income if the gain is allocable to a period of nonqualified use. Generally, this is any period after 2008 during which the property isn’t used as your principal residence. There’s an exception if the home is first used as a principal residence and then converted to nonqualified use.
Losses on the sale of any personal residence aren’t deductible. But if part of your home is rented or used exclusively for your business, the loss attributable to that portion will be deductible, subject to various limitations.
Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It can be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange.
Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.
Income and losses from investment real estate or rental property are passive by definition — unless you’re a real estate professional. Why is this important? Passive income may be subject to the NIIT, and passive losses are deductible only against passive income, with the excess being carried forward. To qualify as a real estate professional, you must annually perform:
- More than 50% of your personal services in real property trades or businesses in which you materially participate, and
- More than 750 hours of service in these businesses during the year.
Each year stands on its own, and there are other nuances to be aware of. If you’re concerned you’ll fail either test and be subject to the 3.8% NIIT or stuck with passive losses, consider increasing your hours so you’ll meet the test. Keep in mind that special rules for spouses may help you meet the 750-hour test. Warning: The IRS has successfully challenged claims of real estate professional status in instances where the taxpayer didn’t keep adequate records of time spent.
Three valuable depreciation-related breaks can help real estate investors reduce
their taxes and some have been enhanced by the TCJA for 2018 and beyond:
1. Bonus depreciation. This additional first-year depreciation allowance is available for qualified improvement property.
2. Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) qualified leasehold-improvement, restaurant and retail-improvement property, subject to certain limits. The TCJA expands the definition of qualified real property eligible for Sec. 179 expensing to include the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems. And certain depreciable tangible personal property used predominantly to furnish lodging is also now eligible for Sec. 179 expensing.
3. Accelerated depreciation. This break allows a shortened recovery period of 15 years — rather than 39 years — for qualified leasehold-improvement, restaurant and retail-improvement property.
It’s possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may even help you keep your income low enough to avoid triggering the 3.8% NIIT and the 20% long-term capital gains rate. (See the Chart “What's the maximum capital gains tax rate?”)
Nevertheless, tread carefully if you’re considering a deferral strategy such as the following:
Installment sale. An installment sale allows you to defer gains by spreading them over
several years as you receive the proceeds. Warning: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received. You could also end up paying more tax if tax rates increase in the future.
Sec. 1031 exchange. Also known as a “like-kind” exchange, this technique allows you to
exchange one real estate investment property for another and defer paying tax on any gain
until you sell the replacement property. Warning: Restrictions and significant risks apply. For example, generally beginning in 2018, the TCJA prohibits Sec. 1031 exchanges for real estate held primarily for sale.