The US Government subsidizes real estate in the tune of trillions of dollars (that’s right, trillions).
Taxpayers Uncle Sam subsidizes real estate by backing and guaranteeing mortgages through Fannie Mae and Freddie Mac. According to the Wall Street Journal, nine out of ten residential mortgages currently originated in 2010 are backed by the government.
How does this benefit you?
You get lower interest rates. The Government’s purchasing spree has pushed down and kept interest rates low for quite some time.
What’s another subsidy you can take advantage of?
Tax breaks for homeowners.
As a homeowner (or potential one), know and take advantage of three of the largest tax breaks legally available to you.
#1. Mortgage Interest Tax Deduction
Like most people, you probably know mortgage interest is a deduction for tax purposes. For simple math, let’s say you make $3000 per month and on average, 20% of your income goes to taxes. If you pay $1500 in mortgage interest per month, that means you can potentially save $300 per month in taxes. Of course you won’t get it back physically every month (unless you adjust your withholding amounts accordingly), but you will realize it at the end of the year when you file your tax return. The calculations may change a bit depending on whether you’re a 1099 contractor or W-2 employee, but you get the idea.
According to the IRS Publication 936 regarding Home Mortgage Interest Deduction, interest on your mortgage might qualify for a tax deduction. However there are requirements and limitations that need to be met in order to qualify for the deduction. See below.
- Debt must be secured by a residence. Loans made to you must be secured the property. Loans not secured by real property are considered personal loans which according to the IRS do not qualify for the deduction.
- You can only deduct interest on two residences. While you can only deduct interest on two residences (this excludes rental properties), you can deduct interest on more than two loans. This scenario occurs when you take out a second or third mortgage on the residences.
- You’re on the hook for the loan. Essentially, you’re the guarantor and the lender has the rights to go after you for the loan.
- A qualified home. You can have up to two qualified homes. For most people, this is their primary residence and a second home (often a vacation or getaway home). Typically, residential rental property does not qualify for this deduction, however it may qualify for other deductions. See Publication 527 for more info.
- If your adjusted gross income (AGI) is more than $166,800 ($83,400 if filing separately), there is a limit on your itemized deduction which means you might not get the full interest deduction.
- Interest paid on loan balances of up to $1M (or $500k if filing separately). If you have a loan balance of greater than $1M you won’t be able to deduct all the interest paid. Uncle Sam is generous, but not that generous.
If you’re a homeowner with a mortgage, you likely fit the criteria above. Even in cases where you might not get the full deduction, you still get something back from paying all that interest.
I don’t suggest factoring in projected tax savings as a major part of the budgeting process in deciding whether or not to purchase a home, , but the projected tax refund will still serve as a nice “surprise” come tax time.
#2. $500,000 Capital Gains Exemption
You’ve heard it said, “Only two things are certain in life: death and taxes.”
That’s a lie.
The former is true, the latter is not .
When you have gains on your stocks and bonds or interest from a certificate of deposit (CD) all these gains are taxable. A $100k gain in a stock investment is great, but you’re still taxed at long-term capital gains, currently 15% for most people. If you’ve owned the stock for less than a year, you’re taxed at the short-term capital gains rate, which is a much higher rate.
Gains on real estate is another ballgame.
One of the greatest benefits of home ownership is the potential to make money and have it TAX FREE (up to $500k). In order to meet this exemption per IRS Publication 523 you have to meet the ownership and use test.
Many have heard about this before, but for those of you who haven’t, here’s the quick rundown:
- Ownership test: You need to have owned the home for at least two years
- Use test: You need to have lived there as a “main home” for at least two years of the most recent five years.
Some examples below.
Meeting the ownership test, but not the use test. You buy a home January 2000 and live there for two years. Then you decide to move out and rent your property for the next 4 years. In this case, while you meet the ownership test, you do not meet the use test. The gain (if any) from the sale of the property is therefore NOT exempt.
Different periods of ownership and use. You purchase a property and live in it for 6 months. You move out (for whatever reason) for the next two and a half years. Then you move back to the home and live in it for one and a half years. You pass the test. As long as you meet both use and ownership test within the most recent five years ending on the date of the sale, you pass the test.
As you can see, this serves as a huge boon to homeowners whose properties have appreciated in value. Having a $200k profit that is tax exempt is like having a $300k profit that is taxable (if you’re in the 34% tax bracket). Huge difference!
#3. 1031 exchange – Deferred Gains
Robert Kiyosaki, author of Rich Dad Poor Dad mentions this as one of the methods “Rich Dad” uses to acquire wealth. Many wealthy property owners use the 1031 exchange to defer taxable gains while allowing them to “parlay” or roll their gains into bigger assets tax free (for a time, at least). Essentially, the 1030 exchange allows you sell your existing property without any current tax on its appreciated value, provided you purchase a “like-kind” property within a certain time frame.
In order it to be a 1031 Exchange the properties have to be “like-kind”. If you’ve taken accounting, this is review. For most of us that haven’t, see the IRS definition below.
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Like-kind applies to assets other than just real estate, but we will limit our discussion only to real estate.
According to IRS:
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Typically, investment properties qualify for like-kind exchanges. Say you purchase a home, a1100sf rental property. Later you want to upgrade to a bigger rental property, or even to a duplex; the new property will likely qualify as like-kind property. You do not get taxed on the appreciation on the sale of the old property so long as you “receive” and pocket no funds from the sale of that property.
Simple steps for doing a like-kind exchange:
- Identify a Qualified Intermediary (QI) (aka exchange facilitator) you’d like to use.
- Sell your existing property.
- Identify property you’d like to buy 45 days. Keep in mind you have to close within 180 days.
Over time, when you compare the difference between deferring taxes and paying taxes every year, the difference is huge. For example, a $10,000 investment that returns 8% annually and requires you to pay 20% gains tax will total $64,306 after 30 years. However, if you defer those gains, pay a one-time long-term capital gains tax of 15%, your investment will be worth $87,033. Deferring your taxes means your investment yields 35% more.
While the long-term return of real estate is 5.68%, the unique tax advantages make real estate a compelling alternative to stocks and bonds. Through the use of tax deductions, deferrals and exemptions, the IRS can make real estate investment worthwhile to you.
Note: This article is not meant to give tax advice, but for real estate owners (or potential owners) to get a general idea of tax benefits that might be available to them. For more information and tax advice, consult a accountant or visit the IRS website.