[Editor's Note: This is a guest post from Stephen L. Nelson, CPA, MBA, MS (taxation) who is a managing member of a CPA firm in Seattle. A prolific writer, he has written more than 160 books which have sold more than five million copies in English, including Quicken for Dummies and QuickBooks for Dummies. One other thing: Nelson insists I point out that he thinks your first investments should not be in real estate but rather in low-cost index funds stored inside tax-deferred accounts like SEP-IRA and 401(k) accounts. We have no financial relationship. A second post by Mr. Nelson will run next week.]
As penance for a snarky comment I made on this blog about another post on real estate investing, White Coat Investor politely (but very fairly) suggested I should post my list of the very best real estate tax loopholes.
Fair enough.
What I’m going to do, however, is break a pretty big topic into a couple of smaller blog posts. In this first post, I want to identify a handful of real estate tax loopholes that you need to know if you own a home or second home. In another post next week, I describe ten other tax loopholes that active real estate investors need to know. And now let’s talk tax loopholes relevant for unintentional real estate investors…
Stephen L. Nelson, CPA
Loophole #1: Section 121 Exclusion
Probably Section 121 represents the most powerful real-estate related loophole.
Note: The Internal Revenue Code is broken into Sections. The well-known 401(k) plan is created in Section 401, for example. I mention this here because if you do know the actual code section, you can easily do additional research by Googling or Binging.
The Section 121 loophole says that if you own a home and live in it as a primary residence for at least two of the previous five years, you can exclude up to $250,000 of the gain if you’re single and up to $500,000 of the gain if you’re married. This is an unbelievably good deal–as good as tax law gives. You probably don’t ever want to walk away from this loophole.
Let me, therefore, point out how people bungle this loophole: The disastrous mistake people interested in real estate investment make when it comes to Section 121 is deciding that they’ll keep a former primary residence as a rental. That almost never makes sense if the property has appreciated and can be sold for a big gain. If you do want to keep a rental in the old neighborhood, no problem, but sell your old house for a tax-free gain and buy the one down the street using the proceeds. Note that this means you get to enjoy the gain on the first house tax free and depreciate a bigger value with the replacement house.
[Editor's Note: Of course, if you're like me and LOST money on your old home turned into a rental, you can use that tax loss to lower the taxes on your other income. It should also be pointed out that you must weigh the tax benefits of not keeping the old home as a rental with the benefit that you can “acquire” this rental without any additional transaction costs, since they are sunk costs.]
Loophole #2: Section 280A Exclusion and a Stranger
Here’s the next loophole you need to know about if you own a home and especially if you own a second home. Section 280A of the Internal Revenue Code, which describes how you do the tax accounting for mixed-use homes, says that if you personally use a home at least 14 days a year and you rent the home for 14 or fewer days a year, you can exclude the rental income from your tax return.
This doesn’t sound like that big a loophole. But it is. And I can give you two real-life examples of how good this exclusion can get.
Say you’ve got a home near the Augusta National Golf Course, where the Master’s Tournament is played. Say it’s a nice home and that you’re willing to rent out the house during the tournament. (Maybe with all the traffic, you and your family would be just as happy getting out of Dodge.) If you get $25,000 a week for the rental, that $50,000 of income for the two weeks is tax free. This is a great deal. [If your marginal tax rate is in the 40-50% range like many docs, this loophole could be worth $25K a year!-ed]
Loophole #3: Section 280A Exclusion and a Related Party
Okay, the best Section 280A-connected gambit is renting to a stranger who pays you cash rent as just described. No question. But if you’ve got a second home, there’s sometimes another angle that you can use if you’re a business owner. If you’ve got a separate business–maybe you’re doing independent contractor work from inside an S corporation, for example—your business can pay you rent. Your business will get to deduct the rent on its tax return. But you won’t need to include the rent as income on your personal return. Now you need to be disciplined about how you set this up. But often you can do this with great result.
Say, for example, that you own a condo in Hawaii. If you use the condo personally for at least 14 days a year, you can rent the condo to your S corporation for up to 14 days a year. Obviously you need to have a real and robust business purpose for the S corporation to rent your condo. But a little cleverness should go a long way. For example, can you attend a continuing medical education course for a few days where your condo is located?
And let me point out something maybe obvious but really important: In some resort areas, peak period nightly rates are astronomical. I mentioned earlier the giant rents homeowners enjoy during the Masters’ Tournament. But you see that same phenomenon in many areas. I’ve got a friend with a nice little bungalow in Palm Springs. The place is wonderful –private pool, large fairway lot, maybe 2,000 square feet—but certainly not opulent. During the Coachella and Stagecoach Music Festivals, however, the property rents for $10,000 to $15,000 a week. That pretty much pays for property for the year. Even after allowing for wear and tear.
Note: Your home or second home needs to have a place to prepare food and a toilet to qualify for Section 280A. Accordingly, a hunting cabin might not qualify if it lacks a toilet, but recreational vehicles and boats which have both kitchens and bathrooms will qualify.
Not Loophole #4: The Section 280A Home Office Deduction
Because someone may wonder about this, can I close by discussing another Section 280A real estate loophole that’s not really a loophole—at least in my mind? I don’t think home owners should spend too much time on the home office deduction–and for two reasons.
First, you probably don’t really qualify for the deduction. To qualify, you need to use your home office not just regularly but also exclusively. I think most people don’t pass the exclusivity test. Sometime during the year, someone probably used your office for personal stuff. [This is why I don't claim this deduction despite having a very viable business I run completely out of my home-ed]
Second, for a home owner, you often don’t increase your tax deductions by much with the home office deduction because you’re often just moving deductions from one page of your tax return to another page. Mortgage interest, property taxes and depreciation, for example, all seem to work like this for a home owner.
What do you think? Which of these deductions have you used? Do you claim the home office deduction? Why or why not? Comment below!
Thank’s for the details on Section 280A! I was aware of the 14-day exception, but hadn’t realized how one put it to such profitable use.
Mr. Nelson,
Thanks for bringing your expertise to this site. If you don’t mind, I have a physician friend who threw a few functions a year for his physician colleagues at his personal home. At these functions they would talk about medicine and network a bit. He used to say how it was a great tax deduction for him.
I am now wondering if this is really what he did.
Can I rent out my personal home by my business for 14 days out of the year and throw an event for my colleagues? I assume as long as we discuss medicine and make it an educational event as well as time for fun this would be ok. Am I missing something?
How do I figure what the going rate for an evening rental on my home would be?
If your business files its own tax return–which means it needs to be a partnership, S corporation or C corporation for tax purposes–the business can pay the landlord rent and use the 14-day rule mentioned here to exclude the rent. That’s the easy part really. I would say there’s little question this *exclusion* works.
The trick however is having something going on at the house that really qualifies as a deduction for the business paying that rent. A dinner party for the business that’s owned by the landlord would seem to me to not very easily fall into that category. (Dinner parties are maybe not really “ordinary and necessary” expenditures of being a professional.) Though maybe you be able to call it something like entertainment expense (though that deduction suffers from the 50% cutback).
BTW what works so easily about your business paying rent for a CME conference you attend in Hawaii is that if you attend a CME conference in Hawaii and you live elsewhere, there’s not any doubt you can deduct lodging expenses.
Oops. Forgot to answer the final question about the nightly rental rate… if you were comfortable saying that your dinner parties were an essential method of marketing your professional services because they result in referrals and so wanted to try this, I think you’d look at the nightly rate paid for nice banquet rooms with equivalent features. Something like a private home rented out for weddings might be pretty workable. (Gosh, if you do want to think about this, be sure to get hardcopy bids from such venues in case you’re audited.)
A final comment: You’d want to pass the giggle test on this. So if you’re paying (say) $28K a year for event venues to do networking, that needs to make economic sense. That amount would not make sense probably for someone making $100K a year but might be pretty reasonable for someone making $500K a year.
Note: If you click my name on this comment, I think you’ll get to my blog. And at the blog there’s a post with more details about vacation homes and the Sec. 280A deduction. It also discusses in a little more detail the example of when a professional musician might be able to deduct $28K via the Sec. 280A deduction and when he or she probably can’t. That same logic probably applies here.
I like the giggle test.
Mr Nelson, thanks for linking to your blog. I will be reading it diligently over the next few weeks and looks like I will be buying your small business deduction book as well. I have heard of your books and your name before and have been looking to purchase something to learn more. Your blog post here has given me that incentive.
I like giggle test, Although I am giggling from my giddiness of possible increased tax savings. At 39.6% Even being able to rent for $1K a night for 1 night a month is worth $4,700
I have an administrative role and having a couple of functions a year is definitely good for recruiting and business. It provides some employee satisfaction, allows us to discuss plans for improvement, as well as possible new sources of revenue or new docs to hire. I think this is definitely legit use of the space. Actually I have the food catered and have it part of the business expense.
If the group is paying you $12K, I think that’s one thing. If you’re just deducting it and the group isn’t paying you, I’m not sure that’s so legit.
Good question,
The group pays me an administrative stipend. Don’t I get to choose how to use it?
If you were holding a group party at a restaurant down the street, would you pay for it with the stipend or bill the group separately?
Also a good question
I would pay for it separately. But I also would not spend that much money to rent a space and would rather use my home which I have done in the past and then pay for some catering.
Right. That’s the argument the IRS would make in an audit, and I think you’d lose it.
Remember, lots of people deduct things that they can’t actually deduct. If you don’t get audited, you simply got away with it. Lots of the deductions I hear docs talk about in the lounge fall into this category. That sounds like one of them to me.
I think renting your primary house as an event venue to your business is probably doable but you would have to be really, really careful. And the BIG issue is how you justify the business paying for example $12K to the landlord (you) for the use of the property.
E.g., the rental rate would have to be reasonable and a true market price. Also, you’d have to really have an expenditure that looks like an ordinary and necessary expense. (No giggling.) Third, I think you’d need to move your family out of the house for the days you’re renting the place out. (You or you and your spouse could probably stay there as hosts… but you’d presumably need business reasons to have the other bedrooms available for attendees…)
FYI, I think using a second home as your lodging for a continuing education conference or a business planning retreat works WAY better because the rules for deducting travel expenses are pretty well defined. You need to be out of town. The trip needs to be primarily for business. And you can’t be extravagant.
My bubble is officially burst.
Even though this post probably only applies to a few people, I appreciate the expertise and knowledge this post brings. Would love to see more like these.
I’ve purchased two or three of Mr. Nelson’s ebooks specifically because he’s able to break down tax concepts in the readable way you’ve seen here.
Glad you made the snarky comment–this was an interesting and well-written post.
I have a question about the benefits of not keeping your primary residence for rental use.
Even if the house did appreciate , but you want to have a rental in your old neighborhood, wouldn’t you expect that all houses appreciated as well? If we’re talking about the cash purchases, you’ll end up paying all of your (tax-free) appreciation money toward another house then, plus sunk costs.
I’m not quite clear on what you’re saying/asking. The benefit of keeping the primary residence for rental use is two fold- 1) If you’re losing money, you can now deduct the loss. 2) If you’re gaining money, you can avoid the purchase costs of buying a separate rental.
The question was about the advice by the guest post about the loophole #1: sell the house if appreciated, keep the tax-free gain and then buy a house down the road if you want to have a rental. I was questioning the financial soundness of this advice
Oh, in that situation you’re balancing two things. The first is the transaction costs. Changing to a different house as your rental would obviously increase those. The second is the tax-free gain you get from a primary residence. See if you change your primary residence to a rental property, you then have to pay taxes on any gains. Unfortunately (and fortunately) for me, that wasn’t the case for me since I lost a bunch of money on residence turned rental property. So for me, it makes sense to make it a rental property for a couple of years so I can now deduct those losses.
So it really comes down to the tax savings vs the transaction costs in the situation where there is a gain on the house.
Here’s a more detailed example, which might make things clearer.
Suppose you bought a place for $175K and it’s now worth $500K. Further assume that your selling costs equal 5% and that your marginal capital gains tax rate (including the ACA surtax) equals 25%.
In this case, you could turn your $175K house in a rental and “have” a $500K rental property. And the conversion would be pretty easy. One or two craigslist ads, right?
But I would say you should sell the place for $500K. You would pay $25K in selling costs. Which means you would in a sense “only” net a $300K profit. (The $500K minus the $25K minus the $175K of original cost.)
However, because of the Sec. 121 exclusion, you would sidestep the roughly $75K of capital gains tax that’ll be owed if you later sell the property as a rental.
In the blog post, my comment about the scenario where you want to keep the house a rental flows from comparing that $75K of cash savings to (using our example) the $25K of selling costs… (which would be a tax deduction on your return BTW)…
Obviously in a scenario like the one described here, the person who doesn’t take the Sec. 121 exclusion—even if they want to have a rental house in the same neighborhood—loses more than $50K cash.
Another point: You can play with the numbers and create scenarios where the aftertax value of
the selling costs is close to the value of the Sec 121 exclusion. So you can’t blindly make a decision. (Not to put words in White Coat Investor’s mouth, but I think this is what he says above…) However, what I see is people simply not understanding the power of the Sec. 121 exclusion.
And a final comment: In a situation like that White Coat Investor has described as his case, there is no Sec. 121 gain, so no exclusion and therefore no lost tax benefit from converting to a rental. In that scenario, converting to a rental may make financial sense. Or it may be the only practical option.
One other thing I meant to mention… in any situation like that described above, what would probably make most sense (if you really do want to be a real estate investor) would be to sell the first home which was probably bought as a residence for your family and then use the $300K of net proceeds to buy another more expensive property that’s specifically suited as a rental… something like a $1M four-plex or eight-plex…
BTW, next week, as the second half of my penance for displaying boorish behavior while commenting, I describe some of the powerful tax loopholes that appear to that sort of “intentional real estate investor” situation.
As White Coat Investor noted in the preface, I really think stuffing things like IRAs and 401(k)s with index funds works best for building savings. But (perhaps slightly at variance with his thoughts about real estate tax accounting rules) I do think that some people probably want to consider direct real estate investment.
I think most people ought to consider direct real estate investment. It’s a great second career combined with an investment and the tax benefits are better than what you get with syndicated real estate due to the ease of exchanging and far better than what you get with REITs.
OK, sorry. I misinterpreted some earlier posts. And for the record, I agree with you. I think people should consider direct real estate investment. Especially people with heavy tax burdens who want to build their savings at a rate faster than things like IRAs and 401(k)s allow.
So if one doesn’t qualify for the sec 121 exclusion due to the conversion of a primary to a rental, can one take advantage of the sec 1031 exchange to sell the rental and buy a more expensive rental tax free?
WCI can you explain what you mean by “if you’re losing money, you can deduct the losses.” Between depreciation and expenses, I show a paper loss every year on my rental property, but I can’t actually deduct this against my income, it just gets carried over from year to year.
Hopefully you eventually start making money and can use up those carried over losses.
You’ll be able to eventually since once your property starts making money (as your payment becomes more principal than interest) you’ll have all those carryover losses to offset your income.
I haven’t seen a lot written about this but it’s something I’m looking into since even though a rental property may show losses now you could offset real income later – still need to run some numbers though.
My husband and I own our home without a mortgage. He purchased the home for $280,000 in 2012 and now it is worth $433,000. We plan to move out in 2016 to a lower cost of living town with a higher salary. If we rent the home for two years and deduct depreciation for those two years ($280,000/27.5 = $10,181 per year), then when we sell the home in 2018 and claim Section 121 exclusion, will we have to repay the depreciation?
Yes.
Just so it’s documented here, the relevant Treasury Regulation is Reg. Sec. 1.121(d), as available here:
https://www.law.cornell.edu/cfr/text/26/1.121-1
You want to read the “example.”
BTW, the tax rate on the depreciation is often a lower rate… (Google on “Unrecaptured Sec. 1250 Gain” for more information.)
Thank you for the tip for the google search, I would have not known the terminology. However, from my internet search it appears the tax rate on the depreciation would be at marginal income rate which would be higher than the capital gain rate of 15%.
This is definitely adding a layer of complexity that we had not considered.
The Unrecaptured Sec. 1250 gain tax rate goes as high as 25% (but will be lower if your ordinary income tax rate is 10% or 15%)… so you need to consider this. Note, though, that if you’re sheltering income taxed at higher rates, you still save money. E.g., if your marginal rate is 40% and your Unrecaptured Sec. 1250 tax rate is 25%, you reduce your taxes even after the “payback.”
As far as renting the property for two years and then selling, in two years you will still be able to use the Sec. 121 exclusion because you’ll be able to look back and say at that point that in two of the last five years you’ve used the property as a primary residence. But here’s the situation people regularly get blindsided by… what if you can’t sell the property after two years of renting? E.g., what if the property takes a long time to sell… or the renters don’t want to move out or they’ve trashed the place and you now need to do some rehab before you can sell. You’re now on a timer… and that last year can go by pretty quickly.
You sound like a great person NOT to turn your home into a rental because it has a big gain. That $150K in appreciation is tax-free right now. It won’t be if you turn it into a rental.
I agree with White Coat Investor. This situation sure looks like one where you don’t want to risk losing the Sec. 121 exclusion. And if you do want to become a landlord, maybe you should sell your former primary residence and replace it with the perfect rental property. Even if that perfect rental property is the house next door.
Couple comments –
1. The rent to yourself through the 280A exclusion – interesting and never heard of this. Seems like you would get challenged in audit and have to move it up the chain to get a supervisor to sign off.
2. Conversion to rental – you can still get a partial 121 exclusion – as in the conversion of the primary to the rental and then sell as long as you owned 2/5 years.
3. You also need to consider financing rates when selling a primary to only buy a rental in the same area. Often times it makes most sense to leverage out the primary house prior to converting and often will make up for the gain especially if you like-kind in the future and get the step up at death. All depending on rates.
Nice little article – look forward to the rest.
Regarding #1, I think the main thing is to have a good rationale for the deduction. I.e., the Sec. 280A thing isn’t the issue. It’s the payment from the related entity. (BTW, I’m not the only CPA who thinks you can do this. It’s received some attention in tax practitioner circles.)
Regarding #2: I agree. But as noted, if you’ve already burned off two of the five years, you’re now looking at a one-year time clock… and I’ve seen clients get clobbered on that.
Regarding #3. The scenario I described was one where the gain is BIG… and when the gain is big, it’s pretty hard to beat an exclusion… especially if your federal rate is basically 25% tax and you’ve got state taxes to stack on top of that.
If you convert a primary residence into a rental, cant one take advantage of a 1031 exchange to buy a larger rental tax free??
I have a little apartment attached to my house. I wonder if I could take advantage of the loophole #2 strategy by renting it out for two weeks?
I think you could. And using something like AirBnB would make such a gambit pretty practical.
Dear Stephen,
Great post, thank you! For those of us in HCOL areas, is the max 1M or 1.1M for mortgage interest deduction? Some people say that 100k needs to be HELOC and others say it can be a 1.1M loan and 100k of the loan considered for improvements.
cc
Good question. Never been asked that one before. I think it’s $1.1M and needs to be two separate loans, but I could be wrong.
I’ve heard mixed things. Should have a known answer considering the mortgages in HCOL areas.
Here is a BH thread:
https://www.bogleheads.org/forum/viewtopic.php?f=2&t=170234
Was hoping Mr. Nelson could chime in.
Thank you again.
From Stephen Nelson via email (wouldn’t post for some reason):
Actually, you can deduct interest (potentially) on $1,1M of mortgage assuming the interest is on a home loan. You don’t need to have a separate $1M mortgage and then a $100K home equity loan. (If you’re interested, Google on Rev. Rul. 2010-25 for more information.)
Two related points, though: First, if you can qualify for a $1.1M mortgage, you very possibly lose the mortgage interest deduction due to the itemized deduction phaseout rules.
Second, if you are losing the home mortgage interest deduction, your mortgage may be quite a bit more expensive than you think. A 4% non-deductible interest rate arguably feels like a 10% mortgage in cases where the taxpayer enjoys a high income.
P.S. If you’re interested in the math, here’s a long-ish blog post that explains: http://evergreensmallbusiness.com/why-early-mortgage-repayment-makes-sense-for-high-income-investors/
Sorry, your reply went through while i was typing.
Thank you again.
I read the link, but I don’t quite see the math working out to lose the mortgage interest deduction.
The standard deduction for MFJ is $12,600. The interest on 1.1M is a lot early-on, even if you can only deduct 80% of that interest. Maybe after 10 or more years the interest is less and it might phase it. Would be helpful to know at which point it phases out.
Could you provide an example for high-income couple such as two physicians?
You don’t keep 80%… you lose up to 80%.
I.e., if you have $60K of deductions, you may lose 80% of these… leaving you with $12K… and in this case, your return probably uses the standard deduction.
BTW, the AMT can kind of end up playing into this calculus, too, because state income taxes and property taxes are AMT preferences.
Two points to bring up:
1. Military capital gains tax – unless they changed things, I believe military have to live in the home 2 of the last 10 years before they pay capital gain tax as long as they continued on active duty after they moved out of the house. While many military rent due short 2-3 year stays in one location, others buy thinking they will stay longer until uncle sam changes their mind for them (you do not miss those days, do you WCI?).
2. If you are renting out a home and use a property manager, then the income is passive income. If you are involved in another passive activity such as some type of company (I am a partner in an Edible Arrangements LLC I am working on getting out of, long story there), the gain on one can help offset the loss on another.
1. No I don’t. Good point on the longer time period.
2. I think it’s passive income even if you don’t use a property manager. You have to actually have real estate professional status for it to be active income, and most docs aren’t going to qualify.
Good point… and note that the suspension of the 5 year time interval applies to military and also foreign service and intelligence services. If someone falls into one of these categories, it’d be worth it to read the actual law which is Sec. 121(d)(9) and available here:
https://www.law.cornell.edu/uscode/text/26/121
Real estate BTW is by definition passive. Also, it’s actually passive for real estate professionals but they aren’t subject to the passive loss limitations.
BTW, the post next week covers a some loopholes related to this stuff.
The 280A exclusion is a great loophole, I’m trying to think of a way I could possibly take advantage of this though. Good to know that I could potentially rent out my primary residence though for 14 days a year and the earnings would be tax free.
It probably wouldn’t make sense to buy a place somewhere like palm springs (I live in LA) to take advantage of it right (all cash or finance)? Or would it?
Palm Springs because of Coachella Music Festival and Stagecoach create (at least temporarily) a really unusual Sec. 280A opportunity. But to get the really big dollar rentals, you need to be basically across the street from the Empire Polo Club, which is where the festivals are. I agree with you, however, that it is tempting…
Perhaps not quite good enough to be the sole factor though… Who knows how long the festivals will go. And neighborhoods and homeowners associations do get “up in arms” about the short-term rentals and so often work to remove that opportunity.
High risk, high reward 🙂
I am going to crunch the numbers just for fun and see what I can come up with. My mom does actually own a second home in PS that she uses more than 14 days/year. So i’ll either recommend to her to take advantage of this or maybe she can rent it out to my business? So maybe that’s a better solution but not sure how the IRS would look upon that although I could justify it as a biz expense and then maybe she could up my inheritance haha?
Be careful as to the 280A exclusion. If the rent is paid by an S corporation to you, and you are an employee of the S corporation (which is often the advised set-up generally to pull out cash as deductible compensation rather than as a dividend), 280A(c)(6) will disallow that deduction. This is an important caveat Stephen seems to have overlooked.
I’m not sure I understand A Tax Lawyer’s comment… but if he or she is saying the home office deduction is tricky or problematic if a S corp uses home office, I agree. (I actually wouldn’t do that.(
Probably almost nobody here (maybe nobody here!) is interested in this point, but many tax accountants think you can get the home office deduction to work for an S corporation if you set up an accountable plan. See here more for info
http://www.taxalmanac.org/index.php/Discussion_Home_Office_for_S-Corp.html
I do think that one can do the 14-day exclusion described in the blog post (and here I quote the code for A Tax Lawyer) due to the language in 280A(g) and see for the fun the paragraph before that 280A(f)(4) and its reference to 162(a)(2)
My business partners were looking for a form a few weeks ago and encountered a website that hosts a lot of fillable forms . If you are requiring it too , here’s
http://goo.gl/8okwNcI have an unhealthy and irrational pet peeve about how the term loophole is used in general discourse. I believe it to mean Congress made an unintentional oversight in the law that allows some to sneak in a tax deduction. However, what most would call a loophole is simply “the Law” and is a method to be used as Congress intended, like the Backdoor Roth. By calling legal and proper use of the Law a loophole, it seems to feed the current narrative in America that success, wealth, and tax deductions are something to be shamed instead of something to be praised and inspired to replicate. I could be all wet on this, but I don’t like to feed the opponents of capitalism and freedom any more than I have to, even if they are misguided.
With that off my chest, I really enjoyed the points in this article! 🙂