Let's be honest: April 15th is the day when we find out how much we really owe in taxes. In homes all over the country, money runs out, and many people who were rich on the 14th are very poor by the 16th.
But tax rules that encourage people to own homes and investment property make the load lighter for those who own property. Not only are these rules good for homeowners, but they are also good for the country as a whole: About 20% of all economic activity in the United States has to do with real estate, so policies that encourage real estate activity are good for everyone.
It seems like the tax code changes almost every year, which means that new forms need to be made and people need to be taught again. Even so, the basics of real estate stay the same, which is good news for buyers, sellers, borrowers, and owners.
Most of the time, mortgage interest is deductible.
The IRS says that there are three types of home mortgage interest that can be deducted:
If you got a mortgage before October 13, 1987, (called grandfathered debt).
Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called "home acquisition debt"), but only if the total of these mortgages and any "grandfathered" debt was $1 million or less in 2005 ($500,000 or less if you are married and filing separately).
Mortgages you took out after October 13, 1987, that weren't to buy, build, or improve your home (called "home equity debt"), but only if the total amount of these mortgages in 2005 was $100,000 or less ($50,000 or less if married filing separately) and didn't exceed the fair market value of your home minus (1) and (2). (2).
When a prime home is sold, it can bring in a lot of money.
When a prime residence is sold, up to $500,000 in profits can be kept out of federal taxes if the owner is married and up to $250,000 if the owner is single, as long as the home has been used as a prime residence for at least two of the last five years. The IRS says that most people can't use this deduction more than once every two years.
There are also rules that could help people who need to sell a first-rate home in less than two years. Under the safe harbor rules from 2004, people may be able to get some capital gains relief in certain situations. For example, if they have to move because their job moved at least 50 miles away or if they have to sell their home because they had more than one child during the same pregnancy, they may be able to get some relief.
Also, the Military Family Tax Relief Act of 2003 says that people in the Armed Forces and the Foreign Service may be able to get special treatment (MFTRA). For example, you may have more time to take a deduction for capital gains or to change your tax return. There may be other helpful parts of MFTRA that you can find out about by talking to a tax expert.
Both buyers and sellers can figure out what points mean.
Imagine a situation in which a home is sold for $500,000 and the owner offers to pay 1 point for the buyer to help close the deal. If a $350,000 mortgage was used to pay for the house, one point would be worth $3,500. Based on what the IRS says, "These fees can't be counted as interest by the seller. But they are a cost of selling that cuts into the amount the seller makes."
In this case, it's interesting that the points can also be deducted when the home is sold.
The IRS says, "The buyer lowers the home's basis by the amount of points paid by the seller and treats the points as if he or she paid them."
In a way, the seller is able to write off the $3,500 cost by taking that amount out of any profit from the sale. When the home is sold at some point in the future, the buyer basically lowers the price they paid for it, which makes any profit bigger. But since up to $500,000 in sale profits may not be taxed, most buyers will not have to pay tax on the seller's contribution for points.
When a prime residence is refinanced, points work differently: the cost of a point has to be taken out over the life of the loan. If the house is sold before the end of the loan term, any costs for points that haven't been taken into account can be used to cut into the owner's profit from the sale.
There may be tax breaks for home offices.
If a part of your home is your main place of business or is used for your employer's convenience, you may be able to write off some of the costs, like mortgage interest, property taxes, and utilities. To get this deduction, you must meet a number of requirements. For more information, see IRS Publication 587, Business Use of Your Home.
If you don't deduct your home office in the year or two before you move, there may be tax benefits to doing so. Talk to a tax expert for more information.
Natural Disasters
The Katrina Emergency Tax Relief Act of 2005 gives people who were hurt by hurricanes Katrina, Rita, or Wilma a lot of tax breaks and other help. Go to the IRS Katrina relief page or call 1-866-562-5227 for more information.
If you have been in a natural disaster like a flood, hurricane, tornado, etc., contact your local congressional office to see if you can get special tax help. If you click here, you can find links to offices in Congress.
Investing in real estate can lead to big tax breaks.
If you own rental property, you should try to rent it out for what the market will bear. You can usually deduct mortgage interest, property taxes, repair costs, management by a third party, depreciation, advertising, insurance, utilities, legal fees, and other costs.
With rental properties, it is possible to have both a positive cash flow and a tax loss. But if your income goes over $100,000, you may no longer be able to use real estate losses to lower your overall tax bill.
If a rental involves family, there may be extra rules and restrictions. Talk to a tax expert for more information.
With a 1031 exchange, investors may be able to put off all capital gains taxes.
With a 1031 transaction, an investment property is traded for "like" real estate. The main rule is that a "replacement" property must be found within 45 days after the "relinquished" property has been sold. The replacement property must be bought within 180 days of the sale of the property that was given up.
The important thing about a 1031 exchange is that the capital gains tax on the property being sold is put off, but it does not go away. What really happens is that the adjusted value of the "relinquished property" is subtracted from the basis of the "replacement property" (the old property).
A 1031 exchange is complicated, so you need a "qualified intermediary" to help you. A qualified intermediary, among other things, holds the money from the sale of the property being given up and uses it to buy the new property. This must be done because, under the rules for 1031 exchanges, the seller of a property that is being given up cannot touch the money from the sale. Instead, the money must be held by a qualified intermediary.
It is also hard to keep track of a 1031 exchange. Basically, you need to figure out how much the property can be sold for, add back any depreciation, and figure out how to pay for it. Ed Horan is a well-known exchange expert and the author of How to Do a Like-Kind Exchange of Real Estate. He has posted a free 13-page exchange guide with an accounting worksheet that you should look over before meeting with a tax pro.
