Double Taxation is a Good Thing – by Ashley Leigh

25 06 2010

People threw tea into the harbor over taxes.  Yet, I’m here to tell you there is way to double up on your tax saving. 

You home is probably harboring hidden tax savings.  You should do something about that!

With the right knowledge, information, and patience, you can make the taxable gain from the sale of your personal residence or a rental property completely disappear … stick the cash in your pocket and legally enjoy your tax savings.

There are two strategies you might consider.

As with all matters such as these, I strongly advise that you discuss this, and all tax matters, with your tax accountant.  I am extremely well-qualified to represent you as your Realtor®.  However, you should consult with tax experts on tax matters.  As initial steps, you will extend your knowledge simply by reading this article and by obtaining IRS Publication 523. 

With the legal caveats out the way, let’s move on!

Strategy 1   Convert a rental property to a primary residence, use it as such for the appropriate period of time, and then sell it for a tax-free gain.  As you might well imagine, there are a few more details involved which are explained in IRS Publication 523, “Selling Your Home” (See the notes at the end of this article to learn how to obtain this useful document.) 

The central point of this situation is that you are allowed to sell a principal residence once every two years and exclude up to $250,000 ($500,000 for a married couple) of the gain on the sale.

Here’s the simple formula:

¨      Own your home for two years

¨      Use it as your principal residence

Result … you can exclude any capital gain tax on the sale (up to the $250,000 or $500,000 limits mentioned earlier). So, to get the maximum bang for your buck, you’ll want to understand the rules and have the patience to wait out the two-year residence period. For those with substantially appreciated real estate in the form of investment properties or second homes, the tax savings could be worth the wait.

The details of how to perform this slight-of-hand is described in IRS Pub 523.  The IRS rules & regulations are not that complicated and easy-to-follow examples are provided in Pub 523.

If your tax-magic strategy involves a now-former rental property, make sure you ask your tax accountant about ‘recapture of depreciation’.  Simply put, depreciation already taken is subject to taxes, no matter what.  The ‘recaptured’ depreciation, however, is taxed at a 25% rate which is less than many of the personal income rates.

By the way, the law says that the property must be used as a principal residence for at least twenty-four months during the five-year period ending on the date of the sale of the residence.

What is cool about this part of the tax-magic law is the 24 months don’t have to be all in a row.  The property must simply be used as a principal residence for a total of 24 months over the 60 months (five years).  That’s may be useful if you have moved around a little and rented your house out for some of the months over the five years.

Strategy 2   Another option would be to convert your current home into a rental property by selling it at fair-market value into a business structure you own. A limited liability company (LLC) is a good choice in most states.   You would still be personally liable for the new mortgage.

The advantages to this option are huge. First, you still get the tax-free gain exclusion deduction when you sell (See Strategy 1 above). Second, your home becomes a source of monthly income. You can refinance your now-rental home to pull some equity out for the purchase of another home, and, depending on how much equity you pull out, you should still be able to keep your “new” rental property cash-flowing, meaning its rental price will still be more than the costs to maintain it (mortgage, insurance, utilities, etc.). You’ll still get the benefit of appreciation, even though the market isn’t appreciating as fast anymore.

Because your LLC paid fair-market value for the now-rental property, it gets the benefit of what is called the “stepped-up” basis, meaning that the sales price is the new basis. This is important, because an investment property can do something your personal residence can’t: Depreciate.

Depreciation is an important reason to get into real estate. The IRS looks at real estate (the buildings, not the land) as something that goes down in value. So every year the building is worth a little less than the year before. After  39 years for residential properties the building

has depreciated to zero.

In practical terms, this means your LLC can take a yearly depreciation deduction against the basis. That’s why being able to step-up the basis to current fair-market value is such a good thing — your LLC has a much larger basis to depreciate against. Depreciation doesn’t cost you a dime.  Yet, it is a legitimate expense which reduces your tax liability. 

As I mentioned earlier, please consult thoroughly with your tax advisor.  There are important considerations you need to clarify.  For example, some rental losses may be classified as passive losses.  And, as mentioned earlier, depreciation must be ‘recaptured’ when the rental property is sold.

So with Strategy 2 you get a huge tax break up front with the gain exclusion, a continuing source of passive income (from the rent) that is taxed at a lower rate than earned W-2 income, a great source of deductions, a potential paper loss that will further reduce your W-2 income (and taxes), and you get to keep control of the property and benefit from its continued appreciation. Good golly!  Let’s throw some more tea into the harbor!

These are but a few examples of how the gain exclusion rules can work for you. There are many others. Tax-saving opportunities exist for married people living apart in two separate homes, for people contemplating divorce, for the elderly who may have moved into an extended-care facility for a period of time, and any number of other different combinations. So, make sure that you can be the best magician that you can be. Understand the rules regarding the sale of a principal residence and help those gains disappear.

Finally, don’t forget …

Call your tax accountant for tax matters

Call me for what really matters … real estate!

NOTE

IRS Publication 523 may be obtained via the Internet:

Point your browser to http://www.irs.gov

On the welcome page, type ‘523’ in the search for field

Select ‘Forms & Publications’ in the within field

Click GO

Click on the title “2006 Publication 523”

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