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Owning a house gives you huge tax advantages. And now the IRS
has made claiming even more tax breaks easy.
By
Jeff
Schnepper
You’ve heard me talk about how owning a home is the
world’s greatest tax shelter. You can deduct mortgage
interest and property taxes. And almost always, you can
keep the gains when you sell your home.
Well, thanks to rules made permanent in 2002 and some
provisional rules, the Internal Revenue Service has gone
and made your home potentially an even greater tax
shelter than it was before -- especially if you use your
home for your business.
Let’s look at all the deductions and benefits you
get when you pay homage to the mortgage gods and go into
more debt than your parents earned in their lifetimes.
We’ll start with the bread-and-butter breaks, and then
hit the new wrinkles.
Taxes
First, you get to deduct all the real property taxes
you pay. That includes all state or local taxes for the
general welfare. It doesn’t count any trash or garbage
collection fees or homeowner association charges
specifically stated and billed.
If you’re escrowing for the taxes, you get the
deduction when your bank makes the payment.
Even if you’re a tenant shareholder in a co-op, you
get to deduct your share of any property taxes paid.
There’s no limit on the number of properties on
which you can deduct taxes paid. If you have 10 homes,
you can deduct the taxes on all 10. (But I must note
that if your deductions are too great you could be
required to use the Alternative Minimum Tax. The AMT is
designed to ensure that everyone pays some tax and does
so by forcing you to take fewer deductions.)
Interest
Uncle Sam wants to put you in a home. Sorry, that
doesn’t sound right. How about, Uncle Sam wants to put
you in a house? In any case, our government wants to
subsidize your home purchase. It does that by making
your interest payments deductible.
Interest paid on the purchase of your principal
residence is deductible. You can even finance additional
land, adjacent to your home, and deduct the interest as
qualified residence interest. You can also deduct the
interest you pay to buy a second residence or vacation
home.
The personal-interest deduction is limited to the
first $1 million of debt. If you plan to spend more than
$1 million for your house, call your accountants.
You can also deduct the interest on as much as
$100,000 worth of home-equity debt. As long as the house
has the equity and the debt is secured by that equity,
the IRS doesn’t care what you do with the borrowed
money. You can use it for whatever you want, including a
vacation or a party to celebrate your newfound
deductions.
If you’re in the 28% bracket, $100 in interest paid
only takes $72 out of your pocket. Uncle Sam pays the
other $28 in income taxes forgone.
Gain
exclusion
Here’s where the IRS gave up the farm this past
year.
Forget about having to roll over your gain into a new
home. Forget about the $125,000 gain exclusion if
you’re age 55 or older. Both are now ancient history.
The new rule is good no matter how old you are. And
though the IRS has been accepting it for about two
years, the new rule is now permanent (with a few new
wrinkles -- the type that are good for you).
If the property was your principal residence for any
two of the five years prior to sale, you can exclude
from taxes $250,000 in gain
($500,000 on a joint return). If you qualify under the
2-out-of-5 rule, you normally sign an affidavit at
settlement. If the house sold for less than
$250,000/$500,000, the sales amount isn’t even
reported to the IRS because you have no tax liability on
that sale.
This isn’t a one-time exclusion. You don’t have
to buy a new house. You can even rent, and you can get
another full exclusion every two years, or whenever you
qualify. But, if you have a $250,000/$500,000 gain every
two years, I want to meet your real-estate agent and get
in on the gold mine.
You can even get a partial
exclusion based on the time of use and ownership. But
you only get the partial exclusion if the sale is
because of:
- A change in place of employment, or
- Health reasons, or
- Unforeseen circumstances.
The
partial exclusion is based on the maximum exclusion, not
on the basis of your actual realized profit. So, say you
bought a home for $250,000 and sold it, because of a job
change, for a $25,000 profit after only one year.
Because the sale was covered by a change in employment, you get a
partial exclusion. It was your principal residence for
one year out of two, so 50% of the maximum exclusion, up
to $125,000 in total gain, is excluded. Since that’s
more than the $25,000 gain you actually realized, no tax
is due on the sale. That’s because you exclude half
the maximum allowed, not the gain itself. It’s a major
tax break. Not many properties are going to appreciate
more than $125,000/$250,000 in one year.
The key is to qualify for the partial exclusion if possible. “Change
in employment” covers anyone who lives in the
household. The person doesn’t even have to be an owner
of the property. The “change in employment” must be
the primary
reason for the move. There’s a “safe harbor” that
assumes that it was the primary reason if your new job
is at least 50 miles farther from the residence sold
than where you used to work.
But if you don’t meet the “safe harbor,” all is not lost.
You’ll just have to prove (if you’re audited) that
it was the primary reason for the move based on the
facts and circumstances of your case.
Health reasons include advanced-age-related infirmities, the need to
move to care for a family member, or to obtain or
provide medical or personal care for a qualified
individual suffering from a disease, illness or injury.
Unforeseen circumstances are where the IRS really became
consumer-friendly. Safe harbors here include divorce,
death, multiple births from the same pregnancy and even
a change in employment or self-employment status that
results in your inability to pay the costs and living
expenses of your household. So, if your income goes
down, or even if your spouse or other co-owner’s
income goes down, you can qualify for a partial or even
a full exclusion.
Even if you don’t qualify for one of these “safe harbors,” you
might still qualify on the basis of your specific facts
and circumstances.
Home
offices
Here’s where, in my opinion, the IRS actually crossed the line. But
it was in favor of the taxpayer. So I’m not going to
complain.
Let’s assume you use 20% of your house as a home office, and you
deduct depreciation and expenses for working in that
part of the house.
In the past, when you sold your house, 20% of the gain wouldn’t
qualify for the exclusion because that 20% wasn’t used
as a “residence.” It was used exclusively as your
office. And check IRS Publication 946 on office property
deductions. (See link at left.)
The IRS doesn’t care even if you used your home 90% for business as
a home office. You can now exclude as much as 100% of
your gain, up to the $250,000/$500,000 limit.
You’re only going to be subject to tax on the gain to the extent of
depreciation taken on the building since May 7, 1997.
But that’s taxed only at 25%.
Wow! That means, if you qualify, there’s no reason not to claim a
home office. And I know there are any numbers of people
who work out of their homes who don’t claim home
offices now.
Dorothy was right: “There’s no place like home.”
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