Capital Gains Exemption

THIS HOMEOWNER EXEMPTION IS BETTER THAN SLICED BREAD…

The exclusion of up to $500,000.00 of capital gains tax as a result of the sale of one’s primary residence can be a great tax benefit to home owners especially since they only use the exemption a few times during their lives.

We, as real estate professionals, ALWAYS need to encourage all of our customers to seek legal or tax advice as all areas of taxation are complicated and there can be traps for the unwary. The goal of this article is to address some of those traps.


LET’S TALK ABOUT THOSE WHO INVEST IN REAL ESTATE…IS THAT POSSSIBLY YOU?

For those who invest in real estate, this special tax code creates potentially wonderful tax planning opportunities. Imagine if you will, your customer (or you) wants to convert their rental property into a primary residence in an attempt to take advance of the primary residence tax exclusion and preclude, not only the capital gains as the property was held as an investment, but to tack on along the time period of the primary residence holding. When combined with the fact that this exemption can be used every two (2) years, this could be wonderful for a property investor.

Sorry. You weren’t the first to look at this opportunity. In fact, this whole scenario goes back as far as about 15 years ago when this whole exemption came into being. However, there are still opportunities, but read on. The Congress has made some changes:


A.      They in the past did preclude depreciation recapture from being eligible for favorable home owner exemption treatment.

B.      They required a longer holding period (5 years) in a Section 1031 tax deferred exchange for those parties who converted the use of their investment property.

C.      More recently (2008), the Congress has forced gains to be allocated between periods of “qualifying” use and periods of “non-qualifying” use of the property.


THE NUTS AND BOLTS OF THE HOMEOWNER EXEMPTION…(SECTION 121 OF THE TAX CODE)…

I think most of my readers have a pretty good understanding of the basic rules. It was created in 1997 by our Congress. No longer do we have to buy a new property [That was an old law]. No longer do we have a once in a life-time $125K exemption [That is also old law]. Our current law is called: “The Taxpayer Relief Act of 1997” and has been modified ever since then.

There are lots of special rules within it and the devil can be in the details. The Publication from the IRS for layman is not a walk in the park, but PUBLICATION 523 can be a great help to understand some of the nuances. Just Google Publication 523 and you can download and print it out. Again, this short article does NOT replace a good consultation with your tax attorney.

That Act allows a homeowner (individual) to exclude up to $250K of capital gain on the sale of a primary residence ($500K for a married couple) so long as the property was owned and the party used the property as their primary residence for at least two (2) of the last five (5) years.

PRACTICE POINTER: Keep in mind that BOTH SPOUSES don’t have to own the house even though this is a community property state. One of the two can own, but BOTH must live at that property to qualify for the $500K exclusion. Isn’t that cool?

One does not have to occupy the property at the time of sale. It is just 2 of the last 5 years. In other words, the time does not need to be even continuous. We just need 720 days in the last 5 years to qualify. If one moves out after qualifying for the initial two (2) years, then one has three (3) years to then sell the property and take advantage of the exclusion rule. Make sure you understand this clearly as it creates many misunderstandings among professionals and homeowners alike.

PRACTICE POINTER: If a seller does not meet the two (2) year rule, still have them talk with their tax counsel as they can get a partial prorated exemption if a change in place of employment, change in health, or “unforeseen circumstances” all of which require a tax attorney or tax counsel to review and advise. As the economy improves folks, sellers will soon again be experiencing this type of issue.


LIMITATION ON USE OF THE EXEMPTION…ONCE EVERY TWO YEARS…

This exemption can be used once every two (2) years.  Remember, so long as the requirement is met there is no limit to the number of times an individual can use that exemption during his or her life. I wonder how many of our customers out there want to move every two years?


VARIATION ON THE THEME…WHAT ABOUT RENTAL PROPERTY?

Most of our customers are not real estate investors. They use this tax savings tool as they move through their life growing a family and later getting smaller as their families mature and move on. During the “good times of rapid appreciation” prior to the recession, many of my clients would “buy up” over time and take advantage of this exemption over and over again. Remember that this is an EMEMPTION and not a deferral. You don’t have to account for that accrued gain afterward like you do in a tax deferred exchange.

Those same people would many times also own rental property and would creatively attempt to move into their rental property taking advantage of the holding period and then excluding ALL of the gain (not only the gain while they lived in the property as well as the gain while it was used as an investment property).  Pretty great ideas!!!! In addition, because of depreciation the gains in the investment part would generally accrue faster and thus a pretty good bang for their tax savings buck if they could pull it off!


WHAT IS TOO GOOD TO BE TRUE IS GENERALLY TOO GOOD TO BE TRUE…ALONG COMES CONGRESS…

Over a period of time, the Congress modified Section 121 (the residence exemption rule) to limit those strategies. The initial rule eliminated the exemption to apply to any gains attributable to depreciation taken on the property when it wasn’t being used as a primary residence. This came into effect on May 6th, 1997 when the original exclusion rule came into effect. So even if you have a blended property and you meet the two year residence rule, that portion of the capital gains that is attributable to depreciation taken will be subject to recapture at generally 25% rates. However, one must read on.


IN 2008, CONGRESS PASSED FURTHER LIMITATIONS…HOUSING ASSISTANCE TAX ACT OF 2008...

So we have to read what happened above and understand that in 2008 Congress further limited the use of this wonderful exemption (in Section 121(b)(4)) specified that the exemption is only available when we have the property ACTUALLY used as a primary residence. The date of that Act is January 1st, 2009.

So this is interesting. The Congress deemed all gains are occurring pro-rata during the whole period of ownership whether owner occupied or not. Periods when the property is owner occupied are “qualifying”. Periods when used for investment are “non-qualifying”. Non-qualifying gains are not exempt!

This is where it can get complicated and this is where it is best to consult with your local attorney.

Happy Investing!

Today's blog courtesy of Ed McFerran, McFerran & Burns

Deductible Mortgage Interest

The mortgage interest deduction is one of the largest tax benefits available to all homeowners and investors who borrow money to fund their real estate purchases. Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.

IRS Publication 936 describes this deduction in detail:

You can deduct home mortgage interest if all the following conditions are met.

• You file Form 1040 and itemize deductions on Schedule A (Form 1040).
  
• The mortgage is a secured debt on a qualified home in which you have an ownership interest. 
  

 Both you and the lender must intend that the loan be repaid.

Fully deductible interest.   In most cases, you can deduct all of your home mortgage interest. How much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how you use the mortgage proceeds.   If all of your mortgages fit into one or more of the following three categories at all times during the year, you can deduct all of the interest on those mortgages.

The three categories are as follows.

1. Mortgages you took out on or before October 13, 1987 (called grandfathered debt).
   
2. Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called home acquisition debt), but only if throughout 2014 these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately).
   
3. Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home (called home equity debt), but only if throughout 2014 these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2).
   

The dollar limits for the second and third categories apply to the combined mortgages on your main home and second home.
You can deduct your home mortgage interest only if your mortgage is a secured debt. A secured debt is one in which you sign an instrument (such as a mortgage, deed of trust, or land contract) that:

• Makes your ownership in a qualified home security for payment of the debt,
  
• Provides, in case of default, that your home could satisfy the debt, and
  
• Is recorded or is otherwise perfected under any state or local law that applies.
  

In other words, your mortgage is a secured debt if you put your home up as collateral to protect the interests of the lender. If you cannot pay the debt, your home can then serve as payment to the lender to satisfy (pay) the debt.

Wraparound mortgage.   This is not a secured debt unless it is recorded or otherwise perfected under state law.

For you to take a home mortgage interest deduction, your debt must be secured by a qualified home. This means your main home or your second home. A home includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.

The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes. Otherwise, it is considered personal interest and is not deductible.

Main home.   You can have only one main home at any one time. This is the home where you ordinarily live most of the time. 

Second home.   A second home is a home that you choose to treat as your second home. 

Second home not rented out.   If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. You do not have to use the home during the year. 

Second home rented out.   If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home.

Amounts charged for services.    Amounts charged by the lender for specific services connected to the loan are not interest. Examples of these charges are:

• Appraisal fees,
  
• Notary fees, and
  
• Preparation costs for the mortgage note or deed of trust.

You cannot deduct these amounts as points either in the year paid or over the life of the mortgage.

You can treat amounts you paid during 2014 for qualified mortgage insurance as home mortgage interest. The insurance must be in connection with home acquisition debt, and the insurance contract must have been issued after 2006.

Qualified mortgage insurance.   Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance.

Limit on deduction.  The only allowable deduction affected by income limits is the deduction for mortgage insurance premiums. If your adjusted gross income is more than $100,000 ($50,000 if your filing status is married filing separately), the amount of your mortgage insurance premiums that are otherwise deductible is reduced and may be eliminated. 

Form 1098.   The mortgage interest statement you receive should show not only the total interest paid during the year, but also your mortgage insurance premiums paid during the year, which may qualify to be treated as deductible mortgage interest.

Understanding the power of your mortgage interest deduction to offset taxable income is a huge advantage to the American homeowner.

Happy Investing!