Although tax planning is likely not at the top of a person’s “to do” list, one of the most important things an investor or homeowner can do is to understand the tax implications between owning and selling a personal residence versus a real estate property.
Owning a home is undoubtedly a big accomplishment in a person’s life, but in terms of tax planning, there are far fewer tax benefits to selling a personal residence versus a real estate property. Let’s start with the sale of a personal residence.
Selling a Personal Residence
When selling your personal residence, your first instinct may be to think that you will be hit with a tax bill on the amount your home appreciated.
For example, if you bought your home for $100,000 and sold it for $500,000, you might calculate your taxable gain to be $400,000.
However, the tax law allows couples to exclude up to $500,000 in gains on the sale of their personal residence, while individuals can exclude up to $250,000.
This certainly is a benefit to homeowners, but keep in mind this applies only to a personal residence.
Tax benefits such as taking depreciation that is available to real estate investors is unavailable to owners of a personal residence. There is an exception, however, if portions of the home are being used exclusively for business purposes, such as a home office.
Selling Real Estate Property
Deductions are the most common tax breaks that real estate investors of rental properties take advantage of. There are many types of deductions available to investors, such as deductions for property tax, property insurance, mortgage interest, property management fees, and advertising expenses.
If the investor chooses to run her real estate business by forming an entity such as an LLC, even more deductions become available such as accountants' fees, attorneys' fees, business equipment, and office space. Although most of the property-related expenses can be deducted at face value, property improvements must be depreciated over time.
One of the biggest tax advantages of owning a property that is being used for business purposes is the ability to take depreciation. It can not be used on a personal residence.
Residential real estate can be depreciated over 27.5 years, while commercial real estate can be depreciated over 39 years. Further, improvements such as new air conditioning, a roof, deck, or similar additions can also be depreciated over time.
Keep in mind that depreciation is only available for investment properties and these properties must be owned for more than one year before the deductions are allowed.
Lastly, the investor must always be aware of the concept of depreciation recapture. Depreciation recapture refers to tax that must be paid on depreciation expenses taken before the property was sold. However, there are ways to defer depreciation recapture such as the Section 1031 exchange.
Section 1031 Exchange
The Section 1031 exchange is one of the most powerful tax planning tools a real estate investor has at their disposal. Instead of selling an investment property and paying tax on gains from the sale, an investor can exchange the proceeds for another “like kind” of property.
The test for what qualifies as “like kind” is complicated, but worth discussing with your tax accountant. There is also no limit on the number of 1031 exchanges an investor can benefit from as long as the “like kind” test has been met.
Tax Deferred Retirement Accounts
Most of us are familiar with IRAs, 401(k)s and related products, but real estate investments can be a powerful tool to minimize one’s tax burden at retirement.
Several products such as a SEP IRA, Solo 401(k), or self-directed IRA have provisions for alternative investments such as real estate that allow your portfolio to grow tax deferred, or in some cases tax free. These products are complicated, so it is best to consult with a tax professional before investing in them.
The best way to see the powerful tax benefits of investing in real estate is with an example. Suppose you purchase a rental property for $100,000, with a 20% down payment. Then in the first year you have the following numbers:
Annual Rental Income $12,000
Net Income $3,000
You can then take a depreciation deduction. This will be the total value of the property divided by the years of useful life.
$100,000 / 27.5 years = $3,636.36
We then combine the net income and the depreciation deduction.
Net Income $3,000.00
Depreciation Deduction ($3,636.36)
Taken together, your taxable income for the year is -$636.36.
You have earned $3,000 in passive income tax free and are able to offset the $636.36 loss from profits you may have earned from another rental property.
As you can see from the discussion above, selling a personal residence versus real estate property might not be ideal from a tax planning or investor perspective, as real estate property held for investment offers a much wider array of tax benefits to minimize your tax burden.
This sort of tax planning, like that provided at Katz, Khayut, & Stroll, is what can help investors get a high ROI from their relationship with a tax accountant. If you are ready to begin your tax planning process, send us a message.