Vernard F. Bond CPA. PLLC

OK.  I think that’s a little strong, but I’m hearing this more today from renters who are considering entering this hot housing market.  By the time I get this question, it’s more like, “Vern, tell me EXACTLY how much more money I will have in my pocket?”

My first response is, “Well, as you know, you are a very special and unique person.”

And I mean this sincerely.  Every person’s tax and budget situation is unique.  But this is a relatively simple math problem and you should be able to get pretty close to your unique number.

So pull out last year’s budget (or check book and credit card statements) and tax return and we’ll get started.

First some savings:

You won’t have a rent payment.  There’s no renter’s insurance.  You can subtract any rental-related utilities you are paying – gas, heat, water, etc.  You may have to travel fewer miles to work, so you might save some gas money.

You probably will have some tax savings IF you itemized deductions.  Remember, your tax savings will not exactly match the amount of your deductions on a one to one basis.  You savings will depend on your tax rate.  So if your tax rate is 20% and your deductions are $1000, your tax savings will be about $200.

So what’s deductible?  Probably the largest deduction is your mortgage interest and, in the early years of your mortgage payments, usually interest makes up a large percentage of this payment.  You can also probably deduct your property tax and mortgage insurance payments.  I say probably because higher income individuals may lose some or all of some deductions.  If you pay points to get your loan, you may be able to deduct them.

If you run a business out of your home, you may be able to deduct home office expenses.

You or I need to run these numbers through last year’s tax return, adjusting for this year’s changes.  This is the only way to get close to what your actual savings might be.

Now some of the costs of home ownership:

I’ve already mentioned a few.  Of course there is the mortgage payment, property taxes, and mortgage insurance.

You will have to get homeowner’s insurance.  You will have utilities.  You may have maintenance costs – whoops, there goes the furnace.  Someone will have to maintain the lawn.  You might have homeowner association dues.  You may need a little remodeling or some fresh paint.

You may need some appliances.  You may need some furniture.

Rack your brain because this is a long term commitment.

There you go.

Add it up and you should have a reasonable dollar estimate of how much cash home ownership will put in (or grab out of) your pocket!

Sale of Your Personal, Principle Residence – Part 1 – The Home Sale Exclusion

If you are married and file a joint tax return, you may be able to exclude up to $500,000 of gain on the sale of your personal residence.  If you are single or married and filing a separate return you may be eligible to exclude up to $250,000 on your return.

This is one of the greatest financial advantages of home ownership. It was implemented under the Taxpayer Relief Act of 1997.  As with all matters related to the tax law, taking full advantage of this exclusion requires careful planning and timing.  We always recommend that you discuss your particular situation with your tax professional.

Measuring a Capital Gain

First you must determine if you made a profit on the sale of your house.  Selling price less adjusted basis equals gain (or loss) on the transaction.  Adjusted basis includes the original purchase price of your house, the cost of any improvements made over the years and expenses related to the sale of your house.

The Calculation:

Selling price of your home

Less:
Original purchase price
Improvements
Selling costs
Purchase expenses
Plus:
Depreciation

Equals:
Gain (or loss)

Now, if you made a profit on the sale of your home and have a taxable capital gain, you must determine if you meet the various requirements to qualify for the exclusion.

The Qualification Rules

Qualifying for the $250,000 Exclusion – 
To qualify for the exclusion, you must meet ALL of the following rules:

1.  Only one home sale can be excluded in any two-year period.

We’ll start with an easy one. You can get the full exclusion on only one home sale every two years.

OK, perhaps this isn’t so easy. As with most tax regulations, there are some exceptions to the general rule. Even if you sell your home before the two-year period is up, these exceptions may allow you to qualify for some of the exclusion. These exceptions are discussed below.

2.  The home you sell must be your “principle residence”.

For most of us, this is a simple one. This is the place you live – home, condo or houseboat.

But what if you own more than one home? Normally, your principle residence is the one where you live most of the time. The IRS provides the following example:

You own and live in a house in the city. You also own a beach house, which you use only during the summer months.The house in the city is your main home.

(For further reading on this topic, you may want to look at some of the excellent documents on the IRS website including Publication 523 – Selling Your Home .)

But what if you used two homes about the same amount of time?

Other factors may be used to determine which is your principle residence.  They include:

• Your place of employment
• The location of your family members’ main home
• Your mailing address for bills and correspondence
• The address listed on your:

Federal and state tax returns
Driver’s license
Car registration
Voter registration card

• The location of the banks you use
• The location of recreational clubs and religious organizations of which you are a member

3.  You must have owned the home for at least two years of the five years before the date of the sale. This is the ownership test.

Example: Lizinka purchased her home on January 1, 2009 and decides to sell it on May 1, 2010. She is not eligible for the exclusion because she has owned it less than two years.

4.  You must have used the home as your principal residence for at least two of the five years before the date of the sale. This is the use test.

Example: Dick purchased his home on June 1, 2004 and lived in it until July 1, 2006. He then moved to Richmond and rented his home to his stepson Campbell until he sold it on January 31, 2010. Dick is eligible for the exclusion because he both owned and used the home as his primary residence for two of the five years before the date of the sale.

Qualifying for the $500,000 Exclusion – 

To qualify for the $500,000 exclusion available for married taxpayers only, there are a few additional requirements:

• You are married and file a joint return for the year.
• Either you or your spouse meets the ownership test.

• Both you and your spouse meet the use test.
• During the two-year period ending the date of the sale, neither you nor your spouse excluded gain from the sale of another home.

If any of these requirements are not met, you will not be eligible for the $500,000 exclusion, but may qualify individually for the $250,000 exclusion.

Example: Dick and Lizinka bought their primary residence on February 1, 2004. They lived in the house until March 1, 2005 when they went on an around the world cruise for three months. They sold their house on February 1, 2007. Dick and Lizinka would be able to exclude any capital gain on the sale. They owned the house for two years and short absences are OK.

Example: Facts are the same as above except that Dick moved to New Mexico on business for one year. In this case, they would not be able to take the exclusion because both have to meet the use test. Extended absences are not permitted.  They may be able to separately meet the tests for the $250,000 exclusion.

Exceptions to the two-year rule – 

As we mentioned above, you may be able to qualify for part of the exclusion if you meet one of the following exceptions.

1)  Change your place of employment: If you have to move due to a change in jobs before you meet the two-year tests, you may qualify for part of the exclusion whether the change was voluntary or involuntary.

2)  Change in health: If a change in residence is due to a disease, illness or injury of a “qualified person” living in the household, you may qualify for the exclusion. This would include caring for a sick relative. Qualified persons include:

• Parent, grandparent, stepmother or stepfather.
• Child, grandchild, stepchild, adopted child, or eligible foster child.
• Brother, sister, stepbrother, stepsister, half-brother or half-sister.
• Mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law or daughter-in-law.
• Uncle, aunt, nephew, niece or cousin.
• You or your spouse.
• A co-owner of the house

3)  Unforeseen circumstances: If you change residences due to an event that could not have been anticipated before purchasing and occupying the residence, you may qualify for a partial exclusion. The IRS provides the following examples:

• An involuntary conversion of your home such as when you house is destroyed or condemned
• Natural or man-made disasters
• Acts of war
• Death, unemployment or change of employment for you, your spouse, a co-owner of the home or another person whose main home is the same as yours
• Divorce or legal separation
• Multiple births from the same pregnancy

How to Calculate the Reduced Exclusion:

If you are only eligible for part of the exclusion, use the following formula to calculate the amount of your exclusion:

Capital gains exclusion (either $500,000 or $250,000)  X  Number of days

The number of days will be the fewest number of days as per the following:

• The period of time you owned your home.
• The period of time you occupied your home.
• The period of time between the date you sold your previous home and the date of the sale of your current home.

You are RISKING your money!

As you can see, taking the home sale exclusion can get pretty complicated pretty quickly. Since $250,000 to $500,000 are at risk, it is important to know how to maximize your exclusion and minimize your taxes. We give all new clients a FREE ONE HOUR CONSULTATION to discuss there situation and help them determine the best tax strategy.  Don’t risk losing money!  Call one of our offices today!

Sale of Your Personal, Principle Residence – Part 2 – Some Tax Planning Considerations

Divorce

Timing is everything.

The estranged couple that files a joint return for the year before the divorce decree becomes final will qualify for the $500,000 exclusion.

If the home is sold in the year of the divorce or in a year after the divorce, only the $250,000 exclusion will be available because the couple will no longer be able to file a joint return.

Renting Your Residence

The ownership test and the use test do not have to be met concurrently as long as both are met within the five-year period. Both of the following sales would qualify for the exclusion.

Example: Dick and Lizinka bought a home in 2004 and used it as their primary residence until they retired and moved to Myrtle Beach in 2007. They rented this house to their son, Campbell, from 2007 until 2009, when the house was sold. They meet both tests.

Example:  Dick and Lizinka rented a house with an option to buy beginning on January 1, 2006. They bought the house on January 1, 2007, and lived in it for one more year before moving to a Myrtle Beach condo. They rented it to their son, Campbell, for an additional year until it was sold on January 1, 2009.  Both tests are met and they qualify for the exclusion.

Another Exception – The Nursing Home

If you own and use a home for one year and then have to move into a state-licensed nursing facility due to a mental or physical disability, you will qualify for the exclusion.

Example:  Dick bought a house on January 1, 2008.  On January 31, 2009, the old warrior was forced into a nursing home on account of his amputation and a flare up of all his old war wounds. Dick would qualify for the exclusion.

Call Us

As you can see, there are a number of tax planning opportunities and tax traps related to the use and disposition of your personal residence. Let us help you pay the minimal tax on the sale of your home.

Sale of Your Personal, Principle Residence – The Home Office Tax Trap

Many of us take legitimate deductions for our home offices. For some, this may include a deduction for depreciation for the part of our home used as a home office.

But watch out!  This may create a future tax liability.

When you sell your house, you may have to “recapture” any depreciation claimed for your home office. Any depreciation recaptured is taxed at a blanket 25% rate.

Example: Dick and Lizinka purchased their house in 2001. In 2005, their son, Campbell moved to Mississippi and his bedroom was converted into a home office.  As part of their home office deduction, Dick and Lizinka deducted $250 in depreciation on their 2006, 2007, and 2008 tax returns. They sold their house in 2009. They must “recapture” this depreciation deduction of $750 on their 2009 tax return.

Their 2009 tax bill will include $187.50 for depreciation claimed for their home office.

Real estate agents can claim quite a few deductions for their expenses.  In general, expenses must be:

1)      Ordinary and necessary for a real estate agent.  Expenses must be common and accepted in the real estate business.

2)      Reasonable – An expense is reasonable if it is not lavish or extravagant given the circumstances.

Some common real estate expense tax deductions include:

• Accounting fees.
• Legal fees.
• Advertising costs including newspaper ads, on-line ads, fliers and postcards.
• Signs and flags.
• Errors and omissions insurance.
• Professional dues including MLS board dues.
• State licensing fees.
• Auto expenses – either standard mileage or actual costs.  These include tolls and parking fees.  There are a number of documentation requirements that need to be met to take auto expenses.
• Office equipment – Be careful.  Some office equipment may have to be expensed over more than one year.
• Office supplies and expenses.
• Seminars and classes related to the business.
• Business-related meals and entertainment – They may only be 50% deductible.
• Gifts – There are dollar limits to gifts.
• Wages paid to employees or family members.
• Home office – There are a number of use-related tests, as well as other limitations to the use of your home.
• Web-related expenses.
• Cell phone.

There are many potential deductions.

Just remember to ask yourself – Is this expense necessary to carry out my business?  Is it a normal expense in my industry?  And is this expense reasonable – not lavish or extravagant?

And remember, all expenses must be documented as per IRS requirements.

Food for Thought – Are Kickbacks a Tax Deductible Business Expense? 

“Though many types of kickbacks are prohibited under federal and state law, kickbacks are not illegal per se. If a kickback does not specifically violate federal or state laws and such kickbacks are made to clients throughout the industry, the kickback may be normal, legal, and even tax deductible. According to section 162(a) of the Internal Revenue Code (26 U.S.C.A. § 162), “all the ordinary and necessary expenses” that an individual or business incurs during the taxable year are deductible, including kickbacks as long as the kickbacks are not illegal and are not made to an official or employee of the federal government or to an official or employee of a foreign government.” – From West’s Encyclopedia of American Law

Give Us A Call 
Have a question about an expense or how it must be documented?  Contact us and we will be glad to help.

It is very important to understand the tax consequences of real estate investing or you could be in for a very unpleasant tax bite.

If you are not buying a primary residence or second home, one of the first tax planning steps is to determine whether you are (or are planning to be) a real estate investor or a flipper. There are very different tax consequences and tax planning requirements associated with each.

Real Estate Investing

Someone how is doing real estate investing holds real estate for long-term appreciation or investment purposes.  The investor holds real estate for more than one year and is interested in maximizing the gain on the investment and is not in the business of buying and selling property for short-term profit.

One of the biggest tax advantages of doing real estate investing is that any gain on a sale is taxed at a maximum of 15%.  The real estate investor is also not normally subject to the 15.3% self-employment tax.  However, the real estate investor is limited to only $3,000 of losses per year on their investments.

Flipping Houses

Someone who is in the business of flipping houses – buying houses, fixing them up, and then selling them for short-term gain – is considered to be a dealer by the IRS.  The dealer holds real estate in the ordinary course of business and anticipates a very quick turnover and profit.

The real estate dealer is taxed very differently from the investor.  The dealer may be taxed at individual income tax rates up to 35% and may also be subject to 15.3% self employment taxes.  Dealers cannot transfer property through a 1031 (like-kind) exchange, cannot use the installment sale method, and cannot take deductions for depreciation.

There is one tax advantage to being a flipper – the dealer is not limited to $3,000 in tax losses per year.

Flipper / Dealer or Real Estate Investor – The Tests

The most important factors used to make this call are the INTENT and PURPOSE of the property acquisition and holding.   Some of the criteria used by the IRS and the courts to determine intent and purpose include:

1. Length of time the property is held – Normally an asset needs to be held for over one year to qualify for capital gains treatment.  This is true of real estate, but this is not a definitive test.  Just because property is held for over one year does not necessarily make it investment property.
2. Number of properties sold in a year – There is no set number, but if you sell only one property in a year, you are probably NOT a dealer.
3. Have a job outside of real estate? – If your primary job is not related to real estate, you are probably engaged in real estate investing.  If you are areal estate broker, real estate developer or associated with a real estate company, you are likely to be considered a flipper / dealer.
4. Have employees who help you sell the properties? – If you have employees who help you sell real estate, you are likely to be a flipper / dealer.
5. Use a business office to sell properties? – If you sell properties out of a business office, you are most likely a flipper / dealer.
6. Time and effort in buying and selling – The more time you spend buying and selling properties, the more likely you are going to be classified as aflipper / dealer.  Some one who is doing real estate investing would be less concerned about moving inventory.
7. Net profits received for the year – The higher your real estate-related profits, the more likely you are a flipper / dealer.  This is particularly true if real estate profits are high in relation to other income you have earned.
8. Extent of improvements made – The more improvements made, the more likely you are a flipper / dealer.
9. Renting property – If you rent property, you are probably holding that property as an investment and not looking to sell it for short-term gain.

These are just some of the criteria used. The criteria and their application may seem vague and subjective. This is why it is extremely important to do some pre-tax planning and take the appropriate actions for your unique situation.

Food For Thought – Flipping / Dealing or Real Estate Investing – How to Tell the Difference

There are times when making the distinction is extremely difficult. Even the tax court seemed to throw up its hands in this item from the CPA Journal and quoted in Carl Zimmerman’s article, “Real Estate Dealer or Investor?” –

“[t]he problem is so severe that, according to the Fifth Circuit Court of Appeals, ‘if a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know and no one else in town can tell you’’ (J.D. Byram, CA-5, 83-1 USTC para. 9381, 705 F. 2d 1418).”

The RISK…
If you are engaging in buying and selling real estate or looking to do this, you are taking a very big risk with your money if you don’t take time and discuss your methods and operation with a tax professional.  We offer all of our new clients a FREE 1 HOUR CONSULTATION to discuss all the details and begin to develop a tax strategy that allows you to keep the most profits possible in your bank account and help you meet your financial goals.  Call us today and let one of our staff schedule a time convenient for you to meet.  We understand Real Estate Investing Tax Laws, and we can help translate them into English for you today!

Vacation Home Tax Rules – Know the Rules, Take Your Vacations, Make Some Money, and Deduct Your Costs (Up to a Point)

If you are considering buying a vacation home that you also rent to others, you may be able to take vacation home tax deductions.  The rental income will be offset by your costs and the tax deductions can reduce your tax bill.

Rental Property vs. Vacation Home

There are very different tax rules associated with rental properties and vacation homes.

If you use your dwelling for personal use less than 14 days during the year or less than 10% of the days you rent it out, the IRS considers this dwelling a rental property, NOT a vacation home.  You may deduct rental expenses from rental income to determine your net rental income.  If expenses exceed income, you may be able to take a loss.

If you use your new dwelling for personal use more than 14 days during the year or more than 10% of the days you rent the unit (whichever is greater), you have a vacation home, subject to its own set of tax rules.  Normally, you may deduct rental expenses from rental income, but you may not take losses or apply losses to reduce other types of income (wage, investment, etc.)   You must also apply expenses in a certain order.

It is EXTREMELY IMPORTANT that you understand the implications of personal use of rental property (or rental of a dwelling unit).  If you don’t consider these issues carefully, you could have some rather unpleasant surprises when it comes to the taxation of rental income while you own the dwelling unit and the taxation of any gain when you sell it.

We have outlined some of the issues, tests, and calculations below.  Hopefully, this material will help you begin to consider the tax implications of your vacation home purchase.

Every situation is unique.  Give us a call and we can help you do some scenario testing and a little tax planning that could help you realize some significant tax savings.

Rental Unit or Vacation Home?

Below you will find a more detailed discussion regarding the tests to determine the type of dwelling you have – rental unit or vacation home; how you would determine which expenses you can deduct from rental income, and how to calculate the proper amounts of your deductions.  To being the process, you must first calculate…

Personal Use Days

• When you rent a dwelling unit that you also retain for personal use and you wish to deduct expenses associated with that unit, you must calculate the number of days during the year it was used for personal use and the number of days it was rented.  The IRS (Publication 527) defines a day of personal use as any day the unit was occupied by the following persons:
• You or any other person who owns an interest in it, unless you rent it to another owner as his or her main home under a shared equity financing agreement.
• A member of your family or a member of the family of any other person who owns an interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only your spouse, brothers and sisters, half-brothers and half-sisters, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
• Anyone under an arrangement that lets you use some other dwelling unit.
• Anyone at less than a fair rental price.

Any days donated to a charity or sold at a fundraising event are also counted as personal use days.

Days you stay in the unit that are used for doing maintenance or repairs are not counted as pesonal days.

Days Rented at a Fair Rental Price

Now you figure the number of days the unit was rented at a fair rental price.  The IRS defines fair rental price as the amount a person unrelated to you would be willing to pay.

Tax Treatment of Income and Expenses

The tax treatment of rental income and expenses for a dwelling unit that you use for personal as well as rental purposes depends on whether you use it as your home.  We touched on this above.

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

1. 14 days, or
2. 10% of the total days it is rented to others at a fair rental price.

If you do not meet these criteria, according to the IRS, you do NOT use the dwelling unit as a home.  Any rental income earned is passive income and losses are passive losses.  There are very complex and special rules associated with passive income and losses.  They are not presented as part of this discussion.  If you have questions about passive income and losses, please contact us and we will be happy to go through these items with you.

If you meet the criteria of the test above, you have a residence, NOT a rental unit.  Calculation of income and losses on this activity are based on a different set of rules than the passive income/loss rules and losses are severely limited.

One Exception to the Use as a Home – Minimal Rental Use

If you rent you home less that 15 days in a year, the income you receive is not treated as rental income.  You owe no taxes on this income.  You may not deduct any rental-related expenses.

This is the exception used by the folks in Augusta, GA who rent their homes to golfers during the week of The Masters golf tournament.  They can pocket the income for renting their homes and pay no taxes on it.  This is also true for those who rent out their homes during the furniture market in High Point.

There are other exceptions which are not discussed in these materials.

Calculation Rental Income and Expenses

If you lived in a dwelling unit more that the greater of 15 days or 10% the total days it was rented at a fair rental price, you must include payments as rental income.  You may deduct expenses as shown below.

If your expenses exceed your rental income (you have a net loss), you may NOT use this loss to offset any other type of income – passive, investment, or active.  You may carry over the net loss to the next tax year to offset the same type of rental income – income from the rental of a home.

You must divide expenses into expenses related to rental use and personal use days.  According to IRS Publication 527:

• Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. (This rule does not apply when determining whether you used the unit as a home.)
• Any day that the unit is available for rent but not actually rented is not a day of rental use.

Example:

Dick and Lizinka’s beach house at Wrightsville beach was available for rent last year.  It was rented for a fair market rent from May 15 through June 30 and from July 14 through August 31 – a total of 96 days.  Dick and Liz used the property from July 1 through 16 and several other days throughout the year.  Their usage totaled 32 days.

Most of their expenses are therefore split – 75% to rental use, 25% to personal use.

Dick had rental income from the beach of $9,000.

Dick and Lizinka had the following expenses related to their beach home:

Mortagage interest     4000
Property taxes           1000
Utilities                       400
Repairs                       600
Depreciation              6000
Advertising                  200

To determine what deductions may be taken against income, you must proceed through the following steps in order.

Step 1 – Calculate deductions for mortgage interest and property taxes:

Seventy five percent of mortgage interest and property taxes can be deducted from rental income = $3,750.

You may use the $1,250 remaining as itemized deductions on Schedule A of Form 1040.

Step 2 – Calculate the direct rental expenses.

Advertising fees are direct rental expensese.  The entire $200 is deductible.

Step 3 – Calculate the expenses directly related to operating or maintaining a dwelling unit.

Utilities and repairs are directly related.  Seventy five percent of these costs can be deducted = $750.

Step 4 – Deduct the depreciation associated with rental use.

Seventy five percent of the depreciation is associated to rental use = $4,500.   Only $4,300 of depreciation expenses can be deducted this year since expenses exceeded revenue.  All expenses total $9,200, rent revenue is $9,000.  So there is a net loss of $200 which is carried over to the following year.

Remember – net deductions cannot exceed rental income for the year.

Give Us a Call

Well, that was easy…

Well, not so much…

This is a very simple example of the tax rules regarding vacation property and does not cover all situations that may arise.  Contact us to go over your particular set of circumstances and avoid the vacation home tax traps.

Confused?  The Tax Court has called these rules “exasperatingly convoluted”.  Bolton v. Commisioner, 77 T.C. 104, 109 (1981).