by Diane Kennedy
It's been 10 years since Congress brought us the homeowner gain exclusion deduction -- one of the most powerful and useful tax-saving tools ever given to homeowners.
The deduction itself is simple: If you have lived in your home for two out of the previous five years, you get a tax break when you sell it. If you're married and you file a joint tax return the first $500,000 of gain (the difference between what you paid to buy the property and what you sold it for) you make on the sale is tax-free. If you're single, you get a tax break on the first $250,000 of gain. What constitutes "living in" is pretty flexible, too. Those two years don't have to be consecutive, nor do you have to physically live in your home every day. The IRS allows you to have temporary absences from your home each year that can be up to 11.5 months! You can literally buy a home, live in it for 2-3 weeks per year for two years and take the entire tax-free gain exclusion.
In most cases, this is a great strategy -- buy, hold for 2 years and sell, tax-free. But what happens when the tax-free gain exclusion amount is less than the profit you make on your home sale?
Sometimes the path of least resistance is the best path of all. Simply by taking the gain exclusion deduction you're saving $75,000 on the first $500,000 in profit. Because you've owned the property for more than one year, the remaining profit will only be taxed at the capital gains rate of 15 percent.
Another option would be to convert the home into a rental property by selling it at fair market value (FMV) into a business structure you own. A limited liability company (LLC) is a good choice in most states.
The advantages to this option are huge. First, you still get the tax-free gain exclusion deduction when you sell. Second, your home becomes a source of monthly income. You can refinance to pull some equity out if you need it for the purchase of another home, and, depending on how much equity you pull out, you should still be able to keep your "new" rental property cash-flowing, meaning the price you rent it out for will still be more than the costs to maintain it (mortgage, insurance, utilities, etc.). You'll still get the benefit of appreciation, even though the market isn't appreciating as fast anymore.
Third, because your LLC paid FMV, it gets the benefit of the "step-up" in basis, meaning that the sales price is the new basis. This is important, because an investment property can do something your personal residence can't: Depreciate.
Depreciation is perhaps the number one (or maybe number two) reason to get into real estate. The government looks at real estate (the buildings, not the land) as something that goes down in value. So every year the building is worth a little less than the year before. After a certain period of time (27 years for commercial, 39 years for residential) the building has depreciated to zero.
In practical terms, this means your LLC can take a yearly depreciation deduction against the basis. That's why being able to step-up the basis to current FMV is such a good thing -- your LLC has a much bigger basis to depreciate against. Depreciation doesn't cost you a dime, either -- it's what we call a "phantom" expense -- which means it is created without you having to spend any money, first.
Depreciation is just one of the deductions you are now able to claim through your LLC. There are hundreds of others. But because depreciation is a phantom expense, it can have a huge impact on your tax bill at the end of the day. Depreciation often contributes to the LLC reporting a paper loss at the end of the year, which can be used to offset your personal W-2 income, meaning your personal tax bill will go down, too. Yet even though the LLC shows a paper loss, it's actually making money for you each and every month.
So you get a huge tax break up front with the gain exclusion, a continuing source of passive income (from the rent) that is taxed at a lower rate than earned W-2 income, a giant source of deductions, a potential paper loss that will further reduce your W-2 income (and taxes), and you get to keep control of the property and benefit from its continued appreciation. What's not to love?
The more you know, the more you can save. In this month's Special Report, we detail four more ways to deal with highly-appreciated homes. It's free for everyone who signs up at this website.
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