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.
There are many tax benefits to home ownership — among them, various deductions. But the return of the itemized deduction reduction could reduce your benefit from some of these breaks:
Property tax deduction. If you’re looking to accelerate or defer deductions (see “Timing income and expenses”), property tax is one expense you may be able to time. You can choose to pay your bill for this year that’s due early next year by December 31, and deduct it this year. Or you can wait until the due date and deduct it next year.
Mortgage interest deduction. 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. Points paid related to your principal residence also may be deductible.
Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible.
Debt forgiveness exclusion. Homeowners who receive debt forgiveness in a foreclosure or a mortgage workout for a principal residence generally don’t have to pay federal income taxes on that forgiveness. Warning: This break expired December 31, 2014, but Congress has revived it for 2015 and 2016.
If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you can take a deduction for the depreciation allocable to the portion of your home used for the office. You can also deduct direct expenses, such as a business-only phone line and office supplies.
For employees, home office expenses are a miscellaneous itemized deduction, which means you’ll enjoy a tax benefit only if your home office expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. If, however, 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 this case, your home office must be your principal place of business or used substantially and regularly to conduct business. The only-use-of-the-space rule also applies.
A new simplified option for claiming the deduction became available beginning in 2013. Under this option, you can deduct $5 per square foot for up to 300 square feet of home office space. So the maximum annual deduction is $1,500. If you choose this option, you can’t deduct depreciation for this portion of your home. But you can take itemized deductions for otherwise allowable mortgage interest and property taxes without allocating them between personal and business use. (See the Case Study “Safe harbor offers home office relief.”)
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. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property. (See the Case Study “Converting a personal residence to a rental property may save taxes.”)
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 a principal 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 for real estate investors expired December 31, 2014. Congress has now extended them:
1. 50% bonus depreciation. This additional first-year depreciation allowance was available for qualifying leasehold improvement property. The break has been extended through 2019, but it will drop to 40% for 2018 and 30% for 2019. On the plus side, beginning in 2016, the qualified improvement property doesn’t have to be leased.
2. Section 179 expensing. This was an election to deduct under Sec. 179 (rather than depreciate over a number of years) up to $250,000 of qualified leasehold-improvement, restaurant and retail-improvement property. The break has been made permanent, and, beginning in 2016, the full Sec. 179 expensing limit will apply (an inflation-adjusted $500,000).
3. Accelerated depreciation. This break allowed a shortened recovery period of 15 — rather than 39 — years for qualified leasehold-improvement, restaurant and retail-improvement property. It has been made permanent.
It’s possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may be less risky from a tax perspective now that ATRA has made capital gains tax rates permanent. (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.
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.