Issue 16 - December 2004

Get ‘real’ and gain: How to boost real-estate profits through tax planning
By Robert Boylan, CPA, PhD and Kim Capriotti, PhD

Your house and the business property you own may be more valuable to you than you realize. Not only do they appreciate in value, but they may also offer substantial ways to lower your tax bills. Here’s how:

THE PERSONAL RESIDENCE ADVANTAGE

Own your home and you can save on your taxes.

• Tax deductible interest. Most people know that one of the main advantages to owning a home is the annual tax deduction for interest on the mortgage of “qualified” property.

Keep in mind that a qualified property is your primary residence. Plus, a qualified property may include one other residence, such as a vacation home that is not rented out at any time during the year or one that is used by the taxpayer for more than 14 days or for 10 percent or more of the days that it is rented out at a fair rental value. (If you use the second residence for less than 14 days, the interest may still be tax deductible, but as a business property, not as personal use property.)

• Tax deduction on secured loans. The tax code also generally allows you to deduct the interest on loans secured by qualified property, with little regard for how the loan proceeds are spent. However, you should be aware that you can only deduct interest on the first $1 million of original mortgage indebtedness and you are limited to the interest on $100,000 of home equity indebtedness.

• Tax-free gains — up to $500,000. What you may not know is that the tax law changed in 1997 — and the change may benefit you. Under the change, every individual is allowed a $250,000 tax-free gain on the sale of a personal residence every two years.

This means that if you are married, you and your spouse together can recognize a tax-free gain of $500,000 on the sale of a personal residence.

For example: If you and your spouse purchased a home on Jan. 1, 2000, for $300,000 and sold the home on Jan. 2, 2002, for $800,000 you would recognize a gain of $500,000. But this gain would be free of tax.

And you do not have to reinvest the proceeds of the sale into another home, which was the provision of the tax law before 1997.

To reap the $500,000 tax-free gain, however, you have to meet two criteria:

1. One or both of you must have owned the residence for two of the last five years; and

2. Both of the taxpayers must have used the house for two of the last five years — although the period does not have to be the same two years.

It is important to note that both must have used the property but only one had to own the property. This allows for some interesting tax strategies.

For example: A couple on the verge of divorce who are not living together can each, separately, live in the house and still qualify for the full $500,000 tax-free gain.

BUSINESS PROPERTY BENEFITS

Owning a personal residence has tax advantages. So does owning business and investment properties that are appreciating.

• Financial leverage. Property that is appreciating gives you financial leverage.

Consider the following simple example. Suppose you finance the purchase of a $500,000 rental property at 80 percent of value, which means that you make a down payment of $100,000 — your financial leverage.

Further assume that the rents you receive from the property put the investment in a "cash break even" situation. This means that the monthly cash outflows of ownership are covered by the cash inflows from the rents.

When the property appreciates by 8 percent — from $500,000 to $540,000 — the return on the amount of actual cash invested is in the range of 40 percent ($40,000 / $100,000). The return to you (the buyer) is “leveraged” due to the borrowing.

• Deferral of gains. Another advantage of owning business property is that the tax law allows you to defer gains on the sale of these properties — provided you replace the property with a "like-kind" property of equal or higher value.

This deferral is a powerful incentive for holding part of your assets in business real estate. Real estate investors exchange properties for many reasons, including acquiring property with prospects for better appreciation, easier management or reduced risk.