It’s that time of the year again—tax season! It is an important time of the year to revisit some of the tax deductions and benefits available to real estate owners and real estate agents. Even with all the negative issues (e.g., inflation, increasing interest rates, higher energy and food prices, and much more) affecting the overall economy in 2021, the real estate industry had yet another record-breaking year. It is important for real estate professionals to be aware of some of the tax breaks available so that they may inform their clients about them and take advantage of them as well.
Tax Deductions Available to Sellers
Selling Costs and Improvements Made Within 90 Days of A Closing
Sellers are permitted to deduct certain expenses incurred in connection with the sale of their residence [see Realtor.com at https://bit.ly/3Jaoxgo]. Some of these expenses include legal fees, title fees, mortgage payoff fees, real estate commissions, advertising costs and staging fees incurred to prepare the home for sale. These deductions are permitted provided they are incurred directly as a result of selling the home. According to Realtor.com in order to take advantage of these deductions, a homeowner must have “lived in the home for at least two of the five years preceding the sale. Another caveat: The home must be a principal residence and not an investment property.” These costs are deducted from the gross proceeds received at closing thereby reducing the gain realized on the sale. In turn, this will ultimately affect the amount of capital gains tax paid, if any, by the seller.
Sellers may also deduct costs incurred within 90 days of a closing in connection with renovating and preparing the home for sale. Normally, home improvements do not include ordinary repair and maintenance items that are considered “normal wear and tear,” and therefore, would not be deductible. However, if a homeowner paints, replaces a water heater, makes repairs to the roof, or undertakes other similar repairs in order to prepare for the sale of the home, those costs may be deducted.
Capital Gains Tax
Sellers may also be required to pay taxes on the profit realized from the sale of their real estate. The tax is known as a capital gains tax. There are two types of capital gains taxes: (1) short-term capital gains; and (2) long-term capital gains. If a seller holds a property (or capital asset) for less than a year, then the seller would pay ordinary income taxes on any gain realized. If, however, a seller holds a property for more than one year, then the seller will benefit from lower capital gains tax rates. Realtor.com provides a simple breakdown of the various capital gains tax rates and brackets:
• Your tax rate is 0% on long-term capital gains if you’re a single filer earning less than $40,400, married filing jointly earning less than $80,800, or head of household earning less than $54,100.
• Your tax rate is 15% on long-term capital gains if you’re a single filer earning between $40,401 and $445,850, married filing jointly earning between $80,801 and $501,600, or head of household earning between $54,101 and $473,750.
• Your tax rate is 20% on long-term capital gains if you’re a single filer earning more than $445,851, married filing jointly earning more than $501,601, or head of household earning more than $473,751. For those earning above $501,601, the rate tops out at 20%.
Personal Residence Capital Gains Exclusion
One important and substantial benefit that is available to owners who sell their primary residence (which may be a single-family home, condominium, cooperative apartment, a mobile home, or a houseboat) is the ability to exclude up to $250,000 for a single person, and up to $500,000 for a married couple filing jointly, from capital gains, provided certain conditions required by the Internal Revenue Service (IRS) are met [see https://bit.ly/3I3Ux4m].
According to the IRS, sellers may only qualify for the exclusion in connection with the “the sale of a home that is [their] principal [i.e., main] residence….” An individual can only have one principal residence at a time. If an individual or individuals own more than one home, then the IRS requires that a “facts and circumstances” test be applied to determine which property is the principal residence. The IRS points out that the time spent in the home is the most important factor.
However, according to the IRS, there are other factors that could be considered as well: (1) “the address listed on your: U.S. Postal Service address, Voter Registration Card, federal and state tax returns, and driver’s license or car registration”; and (2) “[t]he home is near: where you work, where you bank, the residence of one or more family members, and recreational clubs or religious organizations of which you are a member.” This element has become more critical recently because many individuals have purchased new homes out of state and have kept their existing homes due the pandemic. Therefore, it is important to maintain the principal residence status in order to be able to take advantage of the exclusion.
Once the “main” residence test is satisfied, the following conditions must also be met: (1) the seller must have owned the home for at least two years out of the last five years leading up to the date of closing, (2) the seller must have owned the home and used it as the seller’s principal residence for at least two years of the previous five years; and (3) the seller had not sold another principal residence within the last 24 months prior to the date of closing (or, if the seller did sell another home, the seller did not take the exclusion). According to the IRS, the “24 months of residence can fall anywhere within the five-year period, and it doesn’t have to be a single block of time.” A seller may be able to take a partial exclusion, provided certain exceptions are satisfied, in the event the seller was forced to move due to a job-related reason.
“Step-Up in Basis:” Capital Gains on Inherited Homes Being Sold
Another important tax concept for real estate professionals and for individuals who are selling homes that they just inherited is the concept of “stepped-up basis.” When a person passes away and leaves a home (or any real or personal property) to heirs, the heirs do not inherit the cost basis of the decedent. Rather, the heirs receive the property with a “stepped-up” cost basis which is the date of death value of the property rather than the original cost basis of the property at the time the decedent first purchased the property.
For example, if the decedent purchased the home at a cost of $150,000 back in 1990, and the home is worth $1.15 million at the time of decedent’s death, the cost basis would now be $1.15 million, also referred to as the “date of death” value. Therefore, any gain would be calculated starting from the $1.15 million amount rather than the original cost basis amount of $150,000. It is important that an appraisal be obtained so that the new basis, date of death value, can be established. If the property is not sold right away or if it is held for many years, it is important to have the appraisal prepared for IRS purposes so that the value is established as of the date of death and the correct capital gains tax can be determined at the time the property is eventually sold.
Capital Gains Tax on Multi-Family Property Utilized Also As Primary Residence
It is important to note that individuals who utilize a portion of a multi-family property as their primary residence may lose some of the primary residence exclusions. That portion of the property that is used as a rental/investment property will not benefit from the personal residence capital gains exclusion. Only the percentage that is being used as the primary residence will benefit from the exclusion. For example, if the property is a two-family property and a married couple uses one of the apartments as their principal residence (i.e., 50% of the premises), and they sell the property for $1 million, the $500,000 exclusion would only apply to 50% of the sale price, the other 50% would be subject to a capital gains tax calculated on the amount above 50% of the original cost basis. Many are not aware of this, and it is important that sellers discuss this with their accountant so that they are aware of the tax consequences before they place the property on the market.
Additional Deductions and Tax Avoidance Tools For Real Estate Owners
Principal Mortgage and HELOC Interest Deductions
Another benefit of home ownership is that homeowners are permitted to deduct mortgage interest on their tax returns. However, it important to note that there are some limitations on how much interest may be deducted depending on the type of loan and the amount of the loan. There are two type of loans that homeowners usually take out on their homes: (1) a principal mortgage (usually obtained in connection with the initial purchase of the home, also known as “home acquisition debt”), and (2) a home equity loan or home equity line of credit.
Under the 2018 Tax Cuts and Jobs Act, changes were made to the amount of interest that could be deducted on a principal mortgage or “home acquisition debt.” For new loans obtained on or after Dec. 15, 2017, a homeowner is only allowed to deduct interest incurred on debt of up to $750,000. For those homeowners who took out a mortgage prior to Dec. 15, 2017, the higher amount of $1 million, which was the limit previously in effect, still applies.
The 2018 Tax Cuts and Jobs Act significantly changed the rules regarding the home equity loan and home equity line of credit (HELOC). Under the previous tax rules, a homeowner may deduct the interest on up to $100,000 of home equity debt, as long as the total mortgage debt was below $1 million. Now, a homeowner may only deduct interest incurred on a home equity loan or HELOC if the loan proceeds were used specifically for home improvement or renovations purposes. If the proceeds were used to pay off credit card debt, go on vacation, pay for college, or any other non-home improvement reason, then deducting the interest is not permitted. However, if the loan proceeds were used to purchase, build or renovate the home, the new $750,000 limit would apply, and interest incurred on the $750,000 amount would be deductible.
Real Property Taxes Up to $10,000 and Private Mortgage Insurance Deductible
The 2018 Tax Cuts and Jobs Act also reduced the amount of real estate taxes that could be deducted to $10,000. While this has been the subject of much controversy over the past several years, it is important to note that the deduction is still available, although capped at the above amount.
Many homeowners and real estate professionals are also not aware that private mortgage insurance premiums are deductible. Over the past few years, purchasers have been taking out loans (e.g., FHA Loans, etc.) that exceed the 80% loan-to-value ratio threshold requiring the borrower-purchaser to pay private mortgage insurance [see Realtor.com at https://bit.ly/3hYGQZR]. According to Realtor.com, the owner should expect the “PMI payment to range from about 0.3% to 1.15% of your home loan. The most common way to pay PMI loan premiums to your lender is in monthly installments, but you may also be able to make your PMI payments in an upfront cost at your home closing, or roll it into the cost of the loan.” The Mortgage Forgiveness Debt Relief Act of 2007 originally provided for the deductibility of PMI. The Mortgage Insurance Tax Deduction Act of 2021 then reinstated certain deductions and credits for homeowners that expired in 2020.
A Basic Knowledge of Taxes and Tax Consequences Is Important
The issues highlighted herein are just a small segment of the vast tax benefits and tax consequences that exist. It is important for real estate owners and investors to seek the advice of their accountants and tax professionals before they dive into buying, selling and investing in real estate. It is also important for real estate professionals, such as real estate agents, real estate attorneys, property managers and developers to be informed about the various tax benefits and ramifications that are involved in real estate transactions so that guidance may be provided to their clients interested in purchasing or selling real estate.