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Tax Strategies to Know in Residential Real Estate

By: Lance Williams, CPA, Manager

Whether you’ve bought or sold a home in the last few years or have lived in the same house for 30 years, you’ve probably heard how crazy the market is. Many sellers are receiving all-cash offers, sight unseen, within hours of listing.

You must be on top of your game to maximize the sales price, but you should also be cognizant of potential tax ramifications, such as, is the gain taxable? From the buyer’s perspective, what should be considered? Maybe you aren’t buying or selling, but you have a vacation or second home, or you rented out your home for a weekend. There are many income tax rules related to real estate, and other non-income taxes. Below, we will discuss a few common real estate tax scenarios.

Residential Real Estate Tax Strategies for Sellers

Congratulations! Selling a home is always a major accomplishment. Once the boxes are packed and closing is finalized, be sure to call your CPA.

Now that you have an influx of cash, does some need to be set aside for taxes?

How to Determine if the Sale of My House is Taxable?

The sale of your main home may be taxable if your capital gain is more than $250,000, or $500,000 if you file a joint return. Gains less than, or up to, those thresholds are excluded under Section 121.

To qualify, you must meet both the ownership test and the use test. You’re eligible if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods; However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the 2-year period prior to the sale of your home.

If you don’t meet the eligibility test, you may still qualify for a partial exclusion of gain. You can meet the requirements for a partial exclusion if the main reason for your home sale was a change in workplace location, a health issue, or an unforeseeable event. IRS Publication 523 goes into greater detail of these exceptions.

To calculate your gain, and determine your exclusion limit, you’ll need:

  • Selling price
  • Selling expenses
  • Adjusted basis

Selling price and selling expenses are relatively straightforward and can usually be determined from the closing statement. The adjusted basis can be a little more difficult if you’ve owned the home for a number of years and made significant improvements throughout your ownership. The adjusted basis starts with the initial purchase price from when you acquired the home. Typical increases to the adjusted basis would be for improvements that add to the value of your home, prolong its useful life, or adapt it to new uses.

Some examples may include the additions of rooms, garages, or patios, major installations such as a driveway or a swimming pool, and HVAC related systems.

The adjusted basis would decrease for any depreciation expense you’ve taken, if you used your home as a rental or for business purposes, for instance.

You can then plug your numbers into the formula, selling price less selling expenses less adjusted basis equals gain or loss. A positive number indicates a gain; a negative number indicates a loss. Losses are typically not deductible, and gains, in excess of the exclusions if you qualify, are taxable and reported on Schedule D.

Residential Real Estate Tax Strategies for Buyers

First-Time Homebuyer Tax Credit

If this is your first home, you may be eligible for first-time homebuyer credits. In April 2021, lawmakers introduced the First-Time Homebuyer Act of 2021. This bill grants eligible first-time home buyers up to $15,000 in Federal tax credits. Currently, this bill has not become law, but could be retroactive until December 31, 2020.

Tax Incentives for Homeownership

Other tax incentives for homeownership are mortgage interest and state and local taxes, taken on Schedule A as itemized deductions. Both of which were curtained in the Tax Cuts and Jobs Act (TCJA) of 2017.

Under pre-TCJA rules, taxpayers could deduct state and local real estate, personal property, and either income or sales taxes and deduct certain interest payments. Qualified interest included up to $1 million of acquisition debt and $100,000 of home equity debt. The TCJA eliminated or restricted many itemized deductions for tax years 2018 through 2025 and increased the standard deduction. Changes include capping the state and local tax deduction at $10,000 and limited interest on the first $750,000 of acquisition debt and eliminated the deduction for home equity debt that doesn’t otherwise qualify as acquisition debt. Some mortgages, however, are grandfathered under the pre-TCJA rules. Notably, if acquisition debt was obtained before December 15, 2017, the $1 million limit continues to apply.

Your interest on grandfathered debt may have continued to be deducted, but if you sold that home and bought a new one, you’ll now be subject to the $750,000 Section 163(h)(3) limitation. If your mortgage secures the property of your main home and is under $750,000, you can deduct the interest on Schedule A, assuming you itemize. If your mortgage is greater than $750,000, you’ll be able to deduct the pro-rata share of interest on your average mortgage balance, up to the limitation.

For example, you bought a home in December 2019 for $1.1 million. Your mortgage balance was $1,100,000 at 01/01/20, and $1,070,000 on 12/31/20, and paid $40,000 in mortgage interest. Thus, your average mortgage balance for 2020 was $1,085,000. Divide the allowed $750,000 by your average mortgage, which equals 69.124%. That is your allowable mortgage percentage. 69.124% times $40,000, gives you $27,640 of deductible interest on Schedule A.

What Can I Write-Off With My Vacation Home or Second Home?

A common answer to most tax questions; it depends. This question depends on how many days the property is used for rental purposes as opposed to personal purposes. Residences used personally by a taxpayer generally fall into one of three categories when determining their tax treatment under Section 280A.

1. Personal residence with very limited rental use. A residence that is rented for fewer than 15 days during the year.
2. Vacation home with both rental and personal use. Property with (a) personal use that exceeds the greater of 14 days or 10% of rental days and (b) rental use that exceeds 14 days.
3. Rental property with very limited personal use. Property rented during the year and personal use that does not exceed the greater of 14 days or 10% of rental days.

As a note, the property’s designation for tax purposes can change yearly, depending on how the property is used. It is important to keep track of both rental days and personal use days to support the property’s designation. Our question of what you can write-off mainly relates to categories one and two.

Let’s start with category two: Vacation home with both rental and personal use. Property with (a) personal use that exceeds the greater of 14 days or 10% of rental days and (b) rental use that exceeds 14 days.

If property used as a residence is rented more than 14 days, deductions (other than interest and taxes) are limited to the amount of the income from the property. A set of ordering rules applies in determining allowable deductions under Proposed Regulation 1.280A-3(d)(3). If these ordering rules apply, the passive loss limitations are not applicable. Rental income and expenses from vacation homes are reported on Schedule E. Rental expenses are deductible in the following order:

  • Qualified residential interest and taxes for the property that would be deductible on Schedule A if the unit had not been rented; plus rental expenses not attributable to operating or maintaining the dwelling (expenditures to obtain tenants, such as commissions and advertising).
  • Operating expenses (including non-qualified residential interest and excess real estate taxes), except depreciation.
  • Depreciation and other basis adjustments.

When applying these rules, the expenses in the second and third categories cannot produce a taxable loss. Thus, if the deductible interest and taxes completely offset the rental income, the operating expenses and depreciation are not deductible. Any expenses limited under this net income rule are eligible for carryforward to future years, but they remain subject to the net income limitation. In addition to the net income limitation, any property treated as a vacation home is subject to prorating of expenses.

This prorating is required if the property is used personally to any degree, whether or not it meets the residence definition. The expenses attributable to the rental are determined based on the number of days the property is rented at a fair rental to the total days it is occupied during the year. The balance of the expenses is considered personal.

Now category one: Personal residence with very limited rental use. A residence that is rented for fewer than 15 days during the year.

In category one a taxpayer’s property is treated as a residence if during the year it is used for personal purposes for more than 14 days, or more than 10% of the number of rental days if greater.

If such residence is rented for fewer than 15 days during the calendar year, it is considered solely a personal residence. The taxpayer is not entitled to a Schedule E deduction for any expenses associated with the rental of the property, and any income received from the rental use is not taxable. Interest expense, to the extent it is qualified residential interest expense (discussed above), and real estate taxes are deductible as itemized expenses on Schedule A. Effectively, the taxpayer is considered to have received tax-exempt, nonreportable income.

Tax-Free Rental Income

Here’s the likely less familiar scenario, known as the Augusta Rule. Section 280A(g)(2), allows homeowners to rent out their home for up to 14 days per year without being required to report the income on their individual tax return.

The nickname, Augusta Rule, was originally created for the residents of Augusta, Georgia who would rent their homes to spectators staying in town for the Masters Golf Tournament.

The 14-day time frame is very important because 15 rental days would put it into category 2 – home with both rental and personal use. You’d then have to report the income and be limited on allowable deductions.

It should be noted, the rent you charge must be reasonable and fair with respect to the rental market; However, homeowners are likely permitted to charge high rent without being taxed on it where housing is in particular demand for short periods, such as in cities that host major sports or other events.

Conversely, a property is “actually rented” even if the unit is rented for less than fair rental value. In Leslie A. Roy, et al. v. Commissioner, the taxpayers received $1,000 per month for rental of portions of their home and the surrounding property. They alleged the rental payments weren’t equal to the fair rental value of the dwelling unit, claimed that there was, therefore, no “actual rental” of their residence for any period during the tax year, and argued that they were therefore entitled to exclude the rental payments from their gross income under the less-than-15 day de minimis rule. The Tax Court disagreed, finding that taxpayers had actually rented portions of their home and the surrounding property for the entire year, and therefore weren’t entitled to exclude the rental payments under the de minimis rule.

Other Tax Requirements for Residential Real Estate

Aside from income taxes, there is also a multitude of lodging tax requirements that vary from state to state, and even by locality within that state. They go by different names, depending on the jurisdiction, such as Room Occupancy Tax, Lodging Tax, Hotel Tax, Transient Room Tax, and so on. These taxes are usually limited to short-term rentals, which is defined by the jurisdiction, but the typical period is less than 30 days.

Lodging taxes are similar to a sales tax on gross rents but could also be calculated per occupant of a suite, room, or rooms. When you book a hotel room and pay taxes, this is why. Unlike income taxes, there are no deductions to reduce the taxable base. You should collect the tax from the occupant and build that into the overall rental fee. Don’t forget to file all required returns and remit the taxes timely. Certain platforms, such as Airbnb and VRBO will take care of these taxes for you, for a fee. If you don’t use such platform you should check with the city, county, and state where your rental property is located to find out what type of tax you may be subject to.

Buying or Selling – It’s Never Too Late

Real estate is hotter than ever. Markets are nearing or surpassing records and if you’re looking to make a move soon, you don’t want to be left behind. With that being said, during the fast-paced listings, negotiations, and closing, sometimes tax planning can fall by the wayside.

If you have any questions regarding these residential real estate topics, please contact your local Blue & Co. advisor for assistance.

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