22. Tax Breaks

Income Tax Breaks for Homebuyers and Property Owners

 

History has always favored the property owner.  Although property ownership is no longer the requirement for citizenship, nobility or general popularity that it once was, it still maintains a privileged position as a part of the American Dream, as well as a part of smart investment plan.

Over the long term, real estate has proven itself to be a consistently solid investment.  The returns from an investment in real estate are normally assured of keeping with, if not ahead of, inflation.  In the United States, tax codes have made real estate investment and home buying a much more advantageous way to live—as well as a better investment—than renting.

Real estate investors and home owners have several tax-related benefits available to them.  These tax benefits were designed as incentives, with the help of interested lobbyists of course, to promote home ownership and targeted investments.

This article reviews four particular tax benefits available to homeowners and real estate investors:

  • Tax Breaks for Homeowners
  • Tax Credits
  • Deductions for Investors
  • TIFs, Enterprise Zones and Empowerment Zones

Tax Breaks for Homeowners

One of the primary benefits of homeownership for most Americans is the tax deductions and credits available for homeowners.  Deductions produce a reduction of the tax payer’s taxable income.  For the average American, each four to five dollar of tax deduction equals one dollar of income tax that does not have to be paid.

There are three types of deductions available for most homeowners:

  • Loan interest payments
  • Loan points and prepayment penalties
  • Real estate taxes

Previously, mortgage insurance premiums were also tax deductible. However, recent changes have removed this tax deduction — which is very helpful for many homeowners who purchase their property with less than 20% down payment.

Loan Interest Payments

The interest paid on residential mortgage loans (both first mortgages or second mortgages) are often tax-deductible.  These interest deductions, however, are normally limited to only the primary residence occupied by the tax-payer claiming the deduction and second homes not rented out for income.

There are three basic restrictions to observe:

    • The home loans cannot exceed the purchase price or market value of the home.  So a 125% LTV second mortgage may not be tax-deductible, until the total loan-to-value ratio has been brought down to 100% LTV.
    • The mortgage loan amount used to purchase or build the home cannot exceed $1 million. Refinances of first mortgages may continue to be tax-deductible.
    • Home equity loans cannot exceed $100,000; otherwise, they may be ineligible for full deductions.

At the end of each year, residential mortgage lenders send their borrowers a formal notice of how much interest each borrower paid that year on his or her loan.  The consumer then uses that confirmation to calculate any income tax deduction.  Note that the property address information on that notice must match the primary residence address recorded by consumer in the tax return.

Points and Prepayment Penalties

Certain mortgage loan closing costs are also normally tax-deductible.  However, these closing costs are typically restricted to origination and discount points.  Because of this, many borrowers will find it more advantageous to pay points rather than fees.  Note, however, that deductions of these points are handled in different ways:

    • With purchase loans, closing cost deductions can be applied during that year of the purchase.  Because of the tax deductions and lowered payments benefits, paying discount points to lower interest rates can be wise moves for homebuyers who plan to keep the property for at least ten years.
    • With refinance loans, such closing cost deductions must be amortized over the life of the loan.  However, if the property is subsequently refinanced or sold before the end of the refinance loan term, the remaining deductions can be used in that final year.  For example, Plato pays $4,000 in points on a 30-year loan.  That is pure interest charges that he can deduct from his taxes at a rate of $133.33  ($4,000/30).  After five years, he decides to sell his house.  He has already deducted a total of $533.33 over the past four years.  For the year of the sale, he can deduct the remaining $3,466.66 ($4,000 – $533.33) from his taxable income.

Real Estate Taxes

In addition to the preceding loan costs, certain property taxes are also tax-deductible.  The annual ad valorem real estate taxes on the taxpayer’s primary residence are tax deductible in the year in which those taxes are paid.

However, most special assessments are normally not deductible unless they can be classified as an ad valorem real estate tax .  For example, special assessments used to finance street maintenance or repairs of public sewers in the neighborhood can be deducted as real estate tax .

Unfortunately, special assessments used to improve the property cannot be deducted.  This would include a condominium’s renovations, creating sidewalks over a homeowner’s front lawn or installing (not repairing or maintaining) new improvements.  On the plus side, such assessments can be used to offset capital gains when the property is eventually sold.

Tax Credits

To further stimulate private homeownership and real estate investment in target communities, the federal government (in conjunction with state and local governments) provide tax credits for certain investments.

Note that tax credits are actual reductions of the income tax amount itself.  Compare this with deductions to the taxable income.  Each tax credit dollar is one full dollar that the property owner regains.

Here are three tax credit programs available to many homebuyers and homeowners:

  • Energy-saving home improvements. The funding for this program may end soon, but if homeowners make improvements to their home that reduce their energy costs, they can recoup 30% of their investment… up to $1,500.
  • Veteran and military tax credits. Certain veterans and current members of the armed forces who buy a home may be eligible for a tax credit on their purchase, if closed by June 2011.
  • Mortgage Credit Certificate (MCC). The MCC allows first-time homebuyers in target cities and neighborhoods to qualify for tax credits on their mortgage interest—instead of normal deductions.  So instead of indirectly lowering taxes by reducing taxable income, tax credits directly reduce the taxes owed. The MCC programs also allow repeat homebuyers to qualify for tax credits, if they purchase a home in target communities.

Commercial real estate investments may also qualify for tax credits, along the same targeted lines as home purchases.

Deductions for Investors

Commercial, industrial and apartment properties—as well as non-owner-occupied residential properties—normally do not qualify for mortgage interest deduction.  Instead, these investment properties are able to qualify for other deductions and tax breaks:

  • Income losses
  • Depreciation
  • Real estate exchange
  • Income losses

In the past, one of the greatest advantages of investing in real estate was the ability to use real estate tax shelters to offset income from other sources.  This is no longer the case.

Although losses from the income property investments can still be used for deductions, there are strict limitations.  Specifically, the IRS now considers real estate losses as passive income losses and can only be deducted against passive income—revenues from investments in which the investor does not materially participate, such as profits from securities and limited partnerships.

Passive losses can be used to offset income from passive investments.  Passive losses that are not or cannot be deducted can be carried over to later years, without limitation. However, passive losses cannot be deducted from portfolio and active income.

Of course, there are exceptions to these restrictions:

  • Low-wage (relatively speaking) earners. If an investor has adjusted gross income of less than $100,000, that investor can use passive losses from rental properties up to $25,000.  This can be deducted from active income, as well as passive.  If the investor’s income is between $100,000 to $150,000, the allowable deductions are reduced.  However, to qualify for this loophole, the investor must actively participate in the management of the property and own at least 10% of the investment.
  • Real estate professionals. Investors who spend at least 50% of their time or 750 hours a year in real estate leasing, management, development, brokerage, construction, acquisition or conversions can deduct losses from rental investment properties against ordinary income, without the above limits.

Depreciation

The primary deduction claimed by most investment property owners is for depreciation.  The terms depreciation and deduction may be confusing, when one considers that the property itself is constantly appreciating in value.  Depreciation refers to the projected functional value of the property, which is different from its actual market (demand) value.

There is a slight drawback to deducting depreciation.  When it comes time to sell the property, any depreciation claimed must be recaptured. The investor will then have to pay capital gains on the recaptured depreciation, but the recapture tax rate is less than the standard capital gains tax rate. When you consider that taxes paid later is worth less than taxes paid now, the investor still comes out ahead..

Depreciation can only be used on improvements on investment properties―not on the land and not on owner-occupied properties.  There are two methods of calculating depreciation:

  • Straight-Line Method. This approach provides for equal depreciations over the property’s useful life.  The IRS has set useful life as 27.5 years for residential property and 39 years for non-residential real estate.  Properties placed in service before 1987 have varying useful life amounts, based on initial date.
  • Accelerated Cost Recovery System. This method can be used for properties placed in service before 1987 and takes more depreciation in the first years.

Note that depreciation is mandatory for all non-owner-occupied real estate. You cannot opt out of claiming depreciation.

Real Estate Exchange

An advantageous way to defer capital gains on investment properties is through real estate exchanges.  Although IRS rules only allow exchanges for like-kind properties, any investment real estate can be exchanged for any other type of investment real estate.

Most exchanges are multiple exchanges, requiring three or more properties, or Starker exchanges.

TIFs, Enterprise Zones and Empowerment Zones

Federal, state and local governments are in an endless struggle to develop and maintain strong neighborhoods and business communities.  The primary way governments try to stimulate growth, development and, in many cases, redevelopment is through tax incentives.  These incentive programs normally do not require as much funding from the government as direct investments.

Rather, these investment programs encourage private sector developments and investments.  The three most common types of development incentive programs are the following:

  • Tax increment financing (TIF) districts
  • Empowerment zones
  • Enterprise zones

Tax Increment Financing

TIF districts are usually a cooperative effort between state, county and municipal governments that allows them to reinvest anticipated growth revenue into a particular area.  Although there are different variations, the following is a simplified example of how a TIF basically works:

An area is designated a TIF district by the local municipality and county.  Such areas are usually somewhat depressed and are looking for a kick-start―but TIFs can be used on stable areas.

The local taxing authority reassesses the TIF district’s current tax base, prior to any TIF-inspired investments.

For the term of the TIF designation, all tax revenue above that tax base shall be reinvested in that TIF district.  Moreover, the city can actually leverage against such projected growth in tax revenue.

For this example, let’s assume that the area’s annual tax base is $100,000.  If future developments increase that tax base to $150,000, that extra $50,000 is reinvested in the TIF district.

Unbeknownst to many real estate and business investors, they can get a piece of this action.  For example, Keisha buys a vacant lot in a TIF district and invests $200,000 in building a shopping mall.  Assuming that her improvements are worth $7,000 in additional annual tax revenues to the local government, she can negotiate to get a piece of that back as cash rebates or for special improvements to the area.

Another way to take advantage of the TIF would be for a property owner to sell the property to a developer but negotiate to keep future TIF rebates.  That seller would then be able to capitalize on the increased tax revenues brought about by the developer’s improvements to the property.

Empowerment zones

This incentive program is a cooperative effort among federal, state and local government authorities.  Unlike the enterprise zone, empowerment zones attempt to encourage both commercial growth and residential stability.  Empowerment zones offer a mix of guaranteed loans and tax incentives.

Enterprise zones

Like empowerment zones, enterprise zones are also inter-governmental cooperative efforts that offer financial assistance and tax incentives for development in a target area.  However, enterprise zones tend to focus on commercial development.  Typical incentive programs include exemptions on sales taxes, development loans and real estate tax exemptions.

Disclaimer: Consult An Accountant

Because tax laws are constantly changing and the sheer complexity of some of these tax benefits, please consult a tax preparer or accountant.  The preceding information is only brief summaries of some of the tax benefits available to homeowners and real estate investors.

For precise information and guidelines, only a tax preparer or accountant can provide the correct tax benefits and requirements for the specific property you intend to purchase.

 

Go to next HomeBuyer Guide chapter: “23. Creating A Budget”

 

 

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