[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.
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…
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!