Real Estate and Income Taxes: What Is Deductible? What Is Not?

Recently I received a phone call from client who had made an offer to purchase a new home and he and his wife were very excited about this new home – until they got the home inspection report.

Turns out that the Home inspection revealed a faulty hot water heater that would need to be replaced. In addition, the hot water tank had leaked causing damage to floorboards and carpeting, all of which will need to be replaced.

This couple asked whether, if they went through with the purchase of this home and made those repairs, they would be able to deduct those expenses.

SORRY! I told them, they are not deductible.

They then mentioned that wood on the porch was rotting and cited a whole host of other major repairs that would be needed. They asked if any of those expenses would be deductible.

NOPE! I said, they are not.

Their confusion as to what is deductible is understandable as there are different rules for real estate used for income, investment, or rentals versus used as your home.

On investment property, virtually all expenses associated with the property are deductible. Not so for primary residence.

What home expenses are deductible? It’s a very short list:

·       Mortgage interest – only the interest is deductible though, not the full mortgage payment. Keep in mind that a mortgage payment consists of two parts: one part is principal (paying down the debt) and the second part is the interest. Only the interest component is tax deductible.

·       Fully deductible in the year paid are real estate taxes.

·       Also deductible in the year paid are points paid in conjunction with the home purchase. Points are money paid upfront at closing to improve the mortgage rate. Points are among the closing costs, but other closing costs are not deductible – only the points associated with the mortgage. Points associated with a refinance cannot be deducted in full in the year incurred but must be spread out over 27.5 years.

The above mentioned expenses are deductible on Schedule A of your tax return as Itemized Deductions

• NEW IN 2015: PMI is tax deductible in 2015. What is PMI? PMI is private mortgage insurance – it protects the lender if you default on your loan. PMI is usually required if do not have at least 20% equity in your property. PMI expense will be deductible on primary and secondary homes.

Even though deductions are limited, owning your home usually has 3 advantages over renting.

1.       Expenses mentioned previously will usually reduce your overall INCOME taxes. That is because each taxpayer receives the greater of the standard deduction or the total of itemized deductions. The inclusion of real estate taxes and interest usually results in greater itemized deductions which lowers the overall taxes payable. In my book “Money Matters Made Simple: A Woman’s Guide to Financial Health and Wealth” I refer to taxes as a “wealth vampire” because taxes suck the life blood out of your ability to become wealthy. Every dollar saved in taxes is a dollar you can use for your other financial priorities.

2.       Generally real estate appreciates in value.

3.       Over time, real estate usually builds equity.

When combined, these last two points can be very powerful. Let’s illustrate how powerful they can be.

Say you buy a home for $300,000 with $100,000 down and mortgage $200,000 at 4% interest. In 10 years, the mortgage balance is down to approximately $157,000, thus gaining $43,000 in equity.

Continuing with the example, if the property appreciates modest 2% per year, in 10 years the value will have increased to $365,000, resulting in a gain in equity of $65K.

Add the two together: $43,000+$65,000 = $108,000.

If the property is sold, after mortgage is paid off, you have approximately $208,000 cash in hand (not taking closing costs into account). The original equity of $100,000 has grown to $208,000, more than doubling your original equity. This money can be applied towards purchasing another home or towards other financial goals.

There is ANOTHER COMMON AREA OF MISUNDERSTANDING and that concerns the tax treatment on the sale of your home. In the past, you were able to roll over the entire gain from the sale of your home into a new home of equal or greater value to avoid paying capital gains on profit.

Many people mistakenly believe that is still the case – it is not! A 1997 law changed that – ROLLOVER of capital gains NO LONGER APPLIES.

The current treatment allows a certain amount of gain to be exempt from taxation if a married couple, the exemption is the first $500,000 of profit; if single the exemption amount is $250,000. Any profit greater than the exemption amount is subject to income taxes.

Most people are not affected when they sell their home. The people primarily affected are those who have been in their home for a long time. Let’s use an example.

Say you bought a home in Glen Ellyn in 1985 (30 years ago) for $200,000. If a married couple sells in 2015 for $800,000, they would realize a $600,000 gain, of which the first $500,000 is exempt from taxation. The additional $100,000, however, is subject to capital gains tax and is added to income for income tax purposes.

While the capital gains tax rate may be low, the additional income may cause your overall tax rate to be higher as ordinary income (such as wages and interest) are taxed at your highest tax rate based on total income.

To reduce the gain subject to taxes on the sale of your home, keep a good record of improvements you have made. Those costs can be added to your basis resulting in a higher basis when you sell and reducing the profit subject to taxes.

Let’s digress a moment to explain what BASIS is:

-        Basis I not only how much you originally paid for the property, it also includes expenses associated with the purchase of that property.

-        Basis also includes any improvements made to the property. The cost of those improvements add to the basis. Keep in mind that repairs and maintenance have no effect on basis.

Using the prior example, say the married couple added the following improvements:
·         Added a sunroom at a cost of $100,000;
·         Tore down a 1 car garage and replaced it with a 3 car garage for $75,000;
·         Finished the basement at an expense of $100,000.

In this scenario, additions totaled $275,000. When added to the original basis of $200,000, the new basis is $475,000. If the property sells for $800,000, the gain is only $325,000 which is below the exemption amount so no capital gains tax is due.

Again, fixing leaky faucets, painting walls or other repairs and maintenance are expenses and not improvements and usually do not add to basis.

For more elaboration on this topic, please refer to my book “Money Matters Made Simple: A Woman’s Guide to Financial Health and Wealth” which can be purchased from my website, at www.MoneyMattersMadeSimple.com  or at www.Amazon.com.

For more information on Anne, visit www.anneschwab.net.

Rental Real Estate – Good Idea or Bad Idea?

Recently I had a conversation with a young family man who bought a new home and was thinking about renting out his current property instead of selling it. He said that he had heard that rentals in his area were in demand which was pushing up rents the owners received.

 

In the course of our conversation, it became evident that this young man was not aware of the many advantages of owning rental real estate. There are many advantages, here are just a few.

Advantages

In most situations, rental income exceeds property expenses. That additional income can be applied to other priorities important to you.

Expenses associated with the property are tax deductible and those deductions may reduce the amount of income taxes you pay. For instance, if rental expenses exceed income, you can take up to $25,000 in losses that can offset income from other sources such as wages or interest.

What expenses are deductible?

o       Virtually any expenses associated with the property is deductible including, but not limited to, mortgage interest, property tax, operating expenses, repairs or credit check on your prospective tenant.

o       One of the major expenses, however, that is a “paper expense”  (that is, there is no actual cash outlay) is Depreciation. When depreciation is added to the other expenses a paper loss is usually created. Here is our depreciation works.

On residential real estate, depreciation of the property is over 27.5 years. So take for example a property whose basis is $275,000. Divide the basis by 27.5 equal $10,000.  In this example, each year can depreciate $10k against rental income. Adding depreciation to expenses usually results in “paper loss.”
Appreciation
A symbiosis occurs with real estate – as the mortgage principal decreases with each mortgage payment, the property value increases. The symbiosis occurs on the sale of the property resulting in more cash out.

Take for instance a property that is bought for $300,000 with $100,000 down and $200,000 mortgage. Let's say over time the mortgage principal is down to $150,000 and the value appreciates to $350,000. If you sell that property for $350,000 and pay off the mortgage of $150,000, you now have a cash out of $200,000. Remember, only $100,000 was put down on the property and the sale, the cash return has doubled.

Is Now a Good Time to Invest in Real Estate?There is a wise saying in the investment world: Buy low, sell high.

 

The Reality? People inadvertently buy high and sell low. Why does that happen?

 

It happens because investing is counterintuitive. All investments go thru cycles – up, then down, then up, then down ... By the time the general public hears about a good investment, the market is usually accelerating and the inexperienced investor ends up buying at or near the high of the market.

 

When the investment's values fall, the inexperienced investor becomes concerned, which concern turns into panic, which panic causes the casual investor to sell low to stem further losses.

 

The astute investor looks for the undervalued opportunities, not what has been performing better than average so picks up the investments that others have sold at a loss and the cycle starts over.

 

How does that relate to today’s market?

Beginning about 15 years ago, real estate experienced above average appreciation in values. In the Chicago area, real estate averages appreciation of about 3% annually. During the first decade of the 21st century, many areas saw 10%, 20% and even as much as 30% or 40% in some places.

 

Then the market collapsed - big time!

 

Since then, the market has been rebounding, albeit slowly. This has created some tremendous buying opportunities  as many properties are still selling at below market values. Couple that with historically low mortgage rates creates ideal conditions for buying property.

When buying property, though, more than price needs to be considered.

 

Rental real estate can be a good idea – but  it is not for everyone.

If you are considering investing or converting real estate property, keep the following in mind:

o       You will be dealing with renters and all the headaches associated with renters (such as late rents, damage to property, or calls in the middle of the night). If you have no desire to deal with renters than this option may not be for you unless you hire a property manager.

o       You should have enough savings to cover emergencies or major repairs/replacements. If you do not, you may have to use credit which creates more debt.

o       Buy what you can afford, not what you want.

o       There are tax implications on the sale of a rental property of which you should be aware.

Finally, not everyone is eligible to take advantage of  the tax benefits due to income limitations and other restrictions. However, losses are not lost. Unused losses carry forward into future years and can be used to offset income from that property, such as the capital gains on the sale of the property.

 

If you are considering investment real estate, work with a qualified financial planner who can perform the number crunching and provide guidance so that you make informed - and smart  - decisions.

This topic is elaborated on in my book "Money Matters Made Simple: A Woman's Guide to Financial Health and Wealth." To purchase a copy or for a sneak peek, visit www.MoneyMattersMadeSimple.com

For more information on Anne, visit www.anneschwab.net.