The “great American dream”, home ownership, took a great American hit in the mortgage crisis of 2007-2008, followed by lackluster growth until 2016. Projections for 2017 are promising even more growth as interest rates begin rising. If you are a high-income professional (“HIP”) now considering an expensive first or second home, it’s a good time to brush up your knowledge of the tax consequences and opportunities of owning a home.
Mortgage interest You can deduct mortgage interest on up to $1M of loans ($1.1M if you have no home equity loans) used to buy or improve a primary home and one other residence. While it is unlikely any of the homeowners living near me will bump up against this limitation, it’s a different world for our doctor clients who live in high cost of living areas in California, New York, and Florida.
You may not be aware that you have a second home. The IRS defines a home as anything that has sleeping accommodations, a toilet, and cooking facilities. This means that nice boat you were finally able to afford may qualify as your vacation home and you can deduct the related interest on schedule A. If you have more than two homes, choose which home you want to use as your second residence. This choice can change annually.
The marriage penalty The interest deduction limitation of $1M/$1.1M is per married couple. If the couple files separate returns, the deduction is limited to $500k/$550k per spouse. However, if an unmarried couple owns the property jointly, each partner qualifies for the $1M/$1.1M deduction limits. This was definitively decided in the 9th Circuit in 2015 (see Voss v. Commissioner, 796 F.3d)
Home rental The IRS allows you to rent out your home for 14 days, tax free, in any calendar year. At first thought, you may think it absurd that you rent out your primary or secondary residence if you are not in the habit of doing so, but consider these ideas:
- Local events – In Paducah, the quilt show draws guests from all around the world. Hotels and B&Bs for miles around are sold out and lodging is at a premium. The same scenario plays out when the Olympic Games comes to the US, during national sporting events, and so on. You can capitalize, tax free, if an event is located in your vicinity by renting out a room or two via Airbnb, for example. Just make sure you don’t receive rent for over two weeks or the full amount is taxable.
- Corporate events – Do you own a business? Why not have your annual retreat, quarterly corporate meetings, and so forth at your home? Your business can take a deduction for the rent paid to you and you will owe no income taxes on it. You can do the same when out-of-town colleagues visit. Instead of renting a hotel room, rent out a bedroom and pocket the money yourself. Of course, the rent you charge your business must be customary for your location.
Home office – Many of our clients qualify for legitimate home office deductions by setting aside an exclusive area of their homes to conduct business. Even if you have a “day” job (W2) and a second business that you operate from home, you can deduct expenses for your home office if you genuinely need the space and you use it exclusively for your business. This includes administrative activities, marketing, bookkeeping, business planning, and so forth. When your office is located in your home, you can deduct trips related to that business beginning at the end of your driveway.
The IRS has a new “Simplified Method” for calculating the home office deduction. If you have a relatively expensive home ($300k+), you should almost always bypass the simplified method and use the “Actual Expense” method. It will take more time to calculate, but the added deduction will be worth it. If you’re not sure which method is better, ask your CPA to prepare a comparison for your next tax filing.
Many people with a home office use an S-corporation to run their business. S-corporation owners must use an “Accountable Plan” to reimburse themselves (the employee) for the employer’s (the corporation’s) use of the office space. Be sure to discuss this with your CPA.
Exclusion on the sale of the home – Code Section 121 allows an exclusion from capital gains taxes of up to $250k per owner of a residence as long as the home has been the primary residence of each owner for two of the last five years. The same exclusion also applies to unmarried co-owners. But what if one person owns the house until just before selling it? This came up recently with clients in New York. The good news is that, as long as the home has been the main residence for both partners for at least two years, they can marry just before the sale and the full exclusion applies.
Another question I’ve been asked is, “How often can we take the exclusion?” This is a nice problem to have, right? You can exclude gain on the sale of your primary residence every two years. This is a great rule for realtors who frequently move, but what about the rest of us? If you own two homes, both of which have grown in value, you can sell your current primary home, move to your second home for two years, sell that one within the next three years and exclude the gain on both.
Some homeowners convert their primary homes to rental property upon moving to a new location. This may be purposeful or because you simply couldn’t realize the price you wanted at the time. We call these people “accidental landlords”. Even though you are no longer living there, you can still exclude the gain when you do finally sell if you sell within three years of moving out. If you will sell at a loss, then you want to sell three or more years after moving out in order to deduct the capital loss. It’s also worth mentioning that you will have to recapture (pay tax on) any depreciation you deduct on your income tax return during the period of rental. Finally, if you’re a HIP and your rental property doesn’t make a profit, you cannot deduct the loss until the property is sold. It’s all very complicated, which is the reason CPAs were invented.
Is it always a good idea to buy a home? Definitely not. Watch Michelle’s video for five situations in which you should rent instead of buy.