Tax Implications of Buying a Home
If you recently bought a home or are thinking about buying, you probably have a million questions running through your head such as; Do I get a tax break for buying a house? Is mortgage interest tax deductible? How do I maximize my deductions? These are just a few of many good questions around taxes.
Should I choose the standard deduction or itemize? Owning a home means that you can now deduct your property taxes and the interest you pay on your mortgage, which together can be a significant tax break for buying a home. However, many people overestimate the value of these tax deductions, which won’t always add up to more than the standard deduction, especially if you don’t have other things you can itemize, such as charitable contributions or medical expenses. If your itemized deductions don’t add up to more than the amount for your filing status, you should choose the standard deduction.
Is my mortgage tax deductible? You can deduct the interest you pay on your mortgage, points paid to lower the interest rate, property taxes and some parts of the closing costs. Check out IRS Form 1040 to see the line item deductions. There are several online tools, including mortgage interest deduction calculators, to help you estimate how much you can deduct, but it’s always wise to consult a certified public accountant to be sure you’re taking advantage of every possible deduction.
What if I sold my previous home in the same year? Your tax on the sale will depend on whether you made a profit. You can exclude up to $250,000 in profit from the sale of your primary residence ($500,000 for married couples), which is known as a capital gains tax exclusion. There’s one big caveat: You had to have lived in the home for at least two of the previous five years; it cannot be a rental property. However, there are several exceptions to the rule, so you should review the details with an accountant. If you did not make a profit on the sale of your home, you cannot deduct a loss on your taxes.
What if the home I bought was an investment property? The IRS treats primary residences differently than investment properties. Note that any rent that you receive is treated as taxable income, and investment properties do not qualify for the capital gains tax exclusion. The good news is that if you rent your property, there are a variety of expenses you can write off, including repairs, insurance, and maintenance.
If I purchased a second home that I don’t rent out, is the mortgage interest tax deductible? According to IRS.gov, you can claim a mortgage interest tax deduction on a second home if it is not an investment property. If you rent out the residence, you must use it for more than 14 days or more than 10% of the number of days you rent out, whichever is longer. In addition, real estate taxes paid on your secondary residence are generally deductible. For additional details, check out publication 530: Tax Information for Homeowners, published on IRS.gov
Tax Implications of Selling a House
When selling a house, taxes are almost always settled at closing. There’s usually a system in place where both sellers and buyers pay their fair share, with safeguards to ensure all parties are protected.
If you live in an area where property taxes are paid in advance, the seller will have already paid the full year and the buyer will refund the seller a prorated amount. In some areas property taxes are paid in arrears, which means s the homeowner pays for the billing period leading up to the due date; in that case, the seller will refund the buyer.
Capital Gains and Qualifying for the Maximum Exclusion: The type of home is of little importance when it comes to taxes on selling a house. From single-family homes to loft-style condos or houseboats, the taxing ‘powers that be’ allow certain tax breaks for qualifying sales.
You owned and personally used your main home during at least two of the last five years before selling
The home didn’t become yours by way of a like-kind exchange (also known as a 1031 exchange) in the last five years
You haven’t claimed an exclusion for the sale of another home within the last two years
If you are able to exclude your gain, you don’t have to report your home sale on your income tax return. If one or more of the above is not true, you might still be eligible for a different tax break. Visit IRS.gov for more information.
What if I Sold My Investment Property? Investing in residential properties is a wildly popular real estate activity. However, some investors aren’t as informed as they should be about the tax implications.
If you’re trying to sell a house that was never your main residence, or that you’ve never lived in at all, you won’t get the same tax breaks you get when selling a primary residence. In such cases, your second (or third, fourth, etc.) residence is considered an investment property, and the tax burden is very different. Visit IRS.gov for information.
Taxes on Transfers: If you transfer your home’s title (or share of a jointly-owned home), you are considered to have no gain or loss to tax. Your local taxing authority will expect whoever owns the home when the taxes are due to pay the full amount owed.
1031 Like-Kind Exchange
What is a 1031 Like-Kind Exchange? Taxpayers use like-kind exchanges to increase cash flow by deferring taxes on gains realized through the sale of real estate, as long as they reinvest those gains in replacement property.
IRC Section 1031 Tax Deferred Exchanges of Real Estate: A 1031 Exchange, also known as a Starker Trust or Tax Deferred Exchange, is one of the most popular tax strategies available when selling and buying real estate. By structuring the sale and purchase of property as an exchange, the owner can potentially reduce the recognized tax gain to zero. By reducing the taxes owed to the government, more cash is available for the purchase of new property.
Like-Kind Standard in Real Estate Exchanges: In the case of real estate exchanges, the “like‐kind” standard is usually easy to satisfy. Generally, any type of real property interest is like‐kind to any other type of real property. The properties do not have to be of the same nature. For example, a single-family home held as rental property could be exchanged for a vacant parcel of land purchased as an investment. Similarly, a leasehold interest of 30 or more years could be exchanged for a shopping center, and the sale of a fee interest in real estate can be exchanged for a purchaser’s interest under an installment agreement for deed. However, owner occupied residential property does not qualify and property located in the United States is not like‐kind to property located outside of the United States.
Eligibility for 1031 Real Estate Exchanges: Section 1031 of the tax code allows property owners to defer the taxes associated with the sale of their real estate that has been held for business or investment purposes. All types of taxpayers can qualify for the tax benefits–individuals, partnerships, limited liability companies, S corporations, C corporations and trusts (however, the same taxpayer that sells the relinquished property must purchase the replacement property). As long as the requirements for a tax‐deferred exchange are satisfied and the sale proceeds are reinvested in Like‐Kind property, the tax gain can be deferred. In some cases, the tax gain can be deferred indefinitely (exchanges of non‐depreciable land, step‐up in basis upon death, etc.).
Requirements for 1031 Real Estate Exchanges: In order for the taxable gain to be deferred, certain key requirements must be satisfied:
Properties Must Be Exchanged: By itself, a sale followed by a purchase does not qualify as a 1031 Exchange. Instead, the transaction must be treated as an exchange for tax purposes. To convert a sale followed by a purchase into an exchange, a property owner will employ the services of a qualified intermediary (QI) who acts as a middleman to tie the sale to a buyer and the purchase from a seller as a verified exchange. It’s very important for the QI to be contacted prior to the closing of the sale and/or purchase transaction.
Properties Must Be “Like‐Kind”: One of the advantages to exchanging real estate is that almost all real property is considered to be of “Like‐Kind” to all other real property.
Held for Business or Investment Purposes: Both the relinquished property and the replacement property must be held for business or investment purposes. A sale of business property is not required to be replaced with other business property; it can be replaced with investment property or vice versa.
Reinvest the Equity & Exchange Equal or Up in Value: To potentially defer all of the tax gain, a property owner must first reinvest all of the equity in the relinquished property into the replacement property. Second, the purchase price of the property acquired must equal or exceed the sale price of the relinquished property. Typically, this requires debt on the new property to equal or exceed the debt that is paid off on the relinquished property.