The Tax Man Cometh - Not!
Thoughts on the mortgage interest deduction and not paying capital gains on your sale of real estate
The mortgage interest deduction, the primary homeowners’ exemption and tax deferred exchange under Section 1031 of the U.S. Internal Revenue Code, hold great advantages for investors. These tax breaks are the bedrock of making real estate ownership a valuable asset in lifetime investment plans.
The mortgage interest deduction allows deductions from income of interest payments on mortgages of up to 1 million dollars. This mortgage interest deduction has been a part of U.S. tax policy since the federal Tax Code was first enacted in 1913.
The homeowners’ exemption from capital gains tax of gain on the sale of a principal residence is found in the Taxpayer Relief Act of 1997, which provides that a taxpayer can exclude up to $250,000 of gain ($500,000 for qualifying married couples who file jointly) on the sale of a principal residence. The exclusion requires the seller(s) to have owned and occupied the home for two out of the last 5 years ending on the date of sale.
Section 1031 of the Tax Code, known as tax-deferred exchanges, allows taxpayers to defer capital gains taxes on the exchange of “like-kind” properties. It requires both the property to be sold and the property to be purchased to be held for productive use in a trade or business, or for investment purposes. The taxpayer must designate the properties to be purchased within 45 days and closing must occur within 180 days. This benefit is not available for properties used as a primary or second residence. Villas (condominiums and townhouses) in a full time rental program may qualify if they are not used as an owner occupied residence, and owners may occupy it a maximum of 14 days per year.
I am not giving advice on how to apply these laws for your specific benefit. For professional advice on how to do the specifics, consult your attorney, accountant, financial advisor or tax professional. What I will discuss is how these tax breaks can work to enhance the investment value of the real estate you have, and will buy in the future, whether a single primary home, villa, or investment in other real estate.
So, there you are with your family home full of equity and you want to sell and retire to paradise. You are in the catbird seat. With the principal homeowners’ exemption, you can sell and exclude up to $250,000 of gain from capital gains tax (or $500,000 if you are married). You can use that tax-free money for anything, at anytime, and you do not have to re-invest in real estate.
What if primary homeowners rent out their primary home, come to paradise and buy or build a new home. What happens if they move and become full time residents in their new primary home? Then they want to sell their former home later. Oh-oh, problem. Their original home is no longer their primary residence. The homeowners’ exemption has just disappeared.
They could rent or buy a second home, but they need to keep their primary home as their principal residence to be able to sell it later and use the primary homeowners’ exemption. Always consult professional legal and tax advice on the specific plan you want to consider. States have varying laws on legal residency; you may need to vote there, keep a driver’s license and car registered there, and live in that State a substantial amount of time. Inform yourself how your home state laws will affect your home state residency status if you buy a second home or villa.
If you have decided that you are not going to live in your home state when you retire, you may sell that home, take the primary homeowners’ exemption and pocket your profit tax-free. You can buy another property anywhere. You have all the options.
If you have real estate, which you hold for productive use in a trade or business, or for investment purposes, you can use Section 1031, the tax deferred exchange option to sell and invest in a house or villa, if you do not use it as your residence. The house or villa must be held in the productive use of a trade or business, or for investment. If you put that home or villa in a full time rental program, it qualifies. You may stay in that home or villa up to 14 days per year. You could manage your home or villa rental program yourself, or engage a professional short or long-term rental agency. Again, the key to success is getting the professional tax and legal advice from your tax advisor and attorney before you act, not after.
Here is a successful example of a buyer using the Section 1031 tax deferred exchange law. An out of state couple wanted to eventually retire and move permanently to Hilton Head Island. The husband and his professional partner planned to sell the office building they owned, which had substantial gain in equity. He came to Hilton Head Island and shopped for resort villas. The partners sold their office building within a period allowing him to use Section 1031 tax deferral for his share of the proceeds from the sale of the office building. He bought two villas on Hilton Head Island. Both villas are in a rental program, and he and his family are able to stay up to 14 days in each of his villas. In his future, he can use tax deferral for one or both if he wants to trade up, rolling over gain to new properties held for trade, business or investment. He plans, when he retires some years in the future, to move into one of the villas as his primary home. After 2 years or more, he will consider selling the primary home villa, taking the primary homeowners’ exemption, and buy or build another retirement home in a residential plantation on Hilton Head.
Let’s talk about your future. Just click the tab above “Contact Us,” and send me an email or call me. Your email comes directly to me, and I will personally respond to your questions, or requests for information.
Lynn Castner, March 2007
