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Home and Real Estate Tax Deduction Basics - 2023 Mid-year Refresher

There are many ways you can maximize the tax benefits associated with owning a principal residence, vacation home or rental property. Tax planning incorporating forward-looing tax strategies is essential to maximize real estate ownership financial benefits and tax savings.

Home-related Tax Deductions

Property Tax Deduction. Under the TCJA, through 2025, the property tax deduction is subject to a $10,000 limit ($5,000 if you’re married filing separately) on combined deductions for state and local taxes. Higher-income taxpayers owning valuable homes in high-property-tax locations have seen a huge drop in the federal tax benefit they receive from their property tax payments.

Mortgage Interest Deduction. You generally can deduct interest on mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible. Through 2025, the TCJA reduces the mortgage debt limit from $1 million to $750,000 for debt incurred after Dec. 15, 2017, with some limited exceptions.

Home Equity Debt Interest Deduction. Through 2025, the TCJA effectively limits the home equity interest deduction to debt that would qualify for the home mortgage interest deduction. (Under pre-TCJA law, interest was deductible on up to $100,000 of home equity debt used for any purpose, such as to pay off credit card debt or to buy a car.)

Home Office Deduction

Under the TCJA, employees can no longer deduct home office expenses, because of the suspension of miscellaneous deductions subject to the 2% of AGI floor.

If you’re self-employed and your home office is your principal place of business (or used substantially and regularly to conduct business) and it’s the only use of the space, you may be able deduct from your self-employment income a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you may be able to take a deduction for the depreciation allocable to the portion of your home used for the office. You also may be able to deduct direct expenses, such as a business-only phone line and office supplies.

Or you may be able to use the simplified method for calculating the deduction. Under this method, you can deduct $5 per square foot for up to 300 square feet (maximum of $1,500 per year). Although you won't be able to depreciate the portion of your home that’s used as an office — as you could filing Form 8829 — you can claim mortgage interest, property taxes and casualty losses as itemized deductions on Schedule A to the extent otherwise allowable, without needing to apportion them between personal and business use of your home. Of course, there are numerous exceptions and caveats. If this break might apply to you, discuss it with your tax advisor in more detail.

Home Rental Rules

If you rent out all or a portion of your principal residence or second home for less than 15 days during the year, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.

If you rent out your principal residence or second home for 15 days or more, you’ll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation. Exactly what you can deduct depends on whether the home is classified as rental property for tax purposes (based on the amount of personal vs. rental use).

Rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules. Property tax attributable to the rental use of the home isn’t subject to the $10,000 limit on the state and local tax deduction. You can’t deduct any interest that’s attributable to your personal use of the home. However, you can take the personal portion of property tax as an itemized deduction (subject to the $10,000 limit).

Nonrental Property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an itemized deduction for the personal portion of both mortgage interest and property taxes, subject to the applicable limits. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property.

Home Sales

When you sell your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain if you meet certain tests. Gain that qualifies for the exclusion also will be excluded from the NIIT. To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by casualty losses and any depreciation that you may have claimed based on business use. Note: Gain on the sale of a principal residence generally isn’t excluded from income if the gain is allocable to a period of nonqualified use. Generally, this is any period after 2008 during which the property isn’t used as your principal residence. There’s an exception if the home is first used as a principal residence and then converted to nonqualified use.

Losses on the sale of any personal residence aren’t deductible. But if part of your home is rented or used exclusively for your business, the loss attributable to that portion will be deductible, subject to various limitations.

Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It can be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange.

Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.

Real Estate Activity Rules

Income and losses from investment real estate or rental property are passive by definition — unless you’re a real estate professional. Why is this important? Passive income may be subject to the NIIT, and passive losses are deductible only against passive income, with the excess being carried forward. To qualify as a real estate professional, you must annually perform:

  • More than 50% of your personal services in real property trades or businesses in which you materially participate, and

  • More than 750 hours of service in these businesses during the year.

Each year stands on its own, and there are other nuances to be aware of. If you’re concerned you’ll fail either test and be subject to the 3.8% NIIT or stuck with passive losses, consider increasing your hours so you’ll meet the test. Keep in mind that special rules for spouses may help you meet the material participation test. Note: To help withstand IRS scrutiny, be sure to keep adequate records of time spent.

Depreciation-related Breaks

Three valuable depreciation-related breaks may be available to real estate investors:

1. Bonus depreciation. This additional first-year depreciation allowance is available for qualified assets, which before the TCJA included qualified improvement property (QIP) — a definition expanded by the TCJA from leasehold-improvement, restaurant and retail-improvement property. Fortunately, the CARES Act provided a technical correction to the TCJA drafting error that had caused such property to be ineligible. Now, QIP generally will be eligible for bonus depreciation if it was placed in service after December 31, 2017. Note: Under the TCJA, real estate businesses that elect to deduct 100% of their business interest expense are ineligible for bonus depreciation.

2. Section 179 Expensing Election. This allows you to deduct (rather than depreciate over a number of years) qualified property, subject to certain limits. This includes QIP. The TCJA also allows Sec. 179 expensing for certain depreciable tangible personal property used predominantly to furnish lodging and for the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.

3. Accelerated depreciation. This break allows a shortened recovery period of 15 years — rather than 39 years — for QIP. However, the drafting error noted under Bonus depreciation also caused accelerated depreciation for such property to be unavailable. The technical correction in the CARES Act fixed this, though bonus depreciation will provide a bigger current-year tax benefit.

Tax-deferral Strategies for Investment Property

It’s possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may even help you keep your income low enough to avoid triggering the 3.8% NIIT and the 20% long-term capital gains rate.

Nevertheless, tread carefully if you’re considering a deferral strategy such as the following: Installment sale. An installment sale allows you to defer gains by spreading them over several years as you receive the proceeds. Note: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received. You could also end up paying more tax if tax rates increase in the future.

Sec. 1031 exchange. Also known as a “like-kind” exchange, this technique allows you to exchange one real estate investment property for another and defer paying tax on any gain until you sell the replacement property. Warning: Restrictions and significant risks apply. For example, the TCJA prohibits Sec. 1031 exchanges for real estate held primarily for sale. In addition, elimination of this break has been proposed.

Cobalt PacWest | CPAs & Advisors

4225 Executive Square # 600

La Jolla, CA 92037


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