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© Dearborn Real Estate Education, 2005 Real Estate and Taxes! What Every Agent Should Know 3rd Edition Vernon Hoven
© Dearborn Real Estate Education, 2005 Home Mortgage Interest Deduction Learning Objectives Identify the two main requirements for mortgage interest deductions; Discuss the limits on home equity loans when determining tax deductions Summarize the differences between acquisition debt and home equity debt; List the three requirements needed for deducting interest on a qualified residence; and Summarize the general requirements that must be met for home mortgage points to be deductible.
© Dearborn Real Estate Education, 2005 What is Acquisition Indebtedness? Acquisition indebtedness is debt that is incurred to acquire, construct, or substantially improve a taxpayer’s principal or second residence and that is secured by the property.
© Dearborn Real Estate Education, 2005 Home Interest Deduction Formula Interest paid on acquisition debt (see #1 below) Interest paid on home equity debt (#2 below) Qualified-residence interest deduction + + = (1)ACQUISITION DEBT CALCULATION Post -10/12/87 Acquisition (or construct.) Debt + Substantial Improvement Debt Divorce Debt SUBTOTAL (cannot exceed $1,000,000) Pre-10/13/87 Debt (Grandfathered, no limit) TOTAL Allowable Acquisition Debt = = = – Acquisition Debt (above calc #1) Home Equity (Equity debt cannot exceed this amount or $100,000, whichever is lower) (2) HOME EQUITY DEBT CALCULATION Fair Market Value of Residence
© Dearborn Real Estate Education, 2005 Allowable Acquisition Debt Post -10/12/87 Acquisition (or construct.) Debt + Substantial Improvement Debt Divorce Debt SUBTOTAL (cannot exceed $1,000,000) Pre-10/13/87 Debt (Grandfathered, no limit) TOTAL Allowable Acquisition Debt = =
© Dearborn Real Estate Education, 2005 What is Home Equity Indebtedness? Home equity indebtedness is debt (other than acquisition indebtedness) that is secured by the taxpayer’s principal or second residence and does not exceed fair market value of the qualified residence(s) [§163(h)(3)(C)(i)].
© Dearborn Real Estate Education, 2005 How Does a Debt Become Secure? The qualified residence must be specified as security for the payment of the debt and In the event of default, the residence could be subjected to the satisfaction of the debt and It is recorded (or otherwise perfected under local or Texas state law [§ T(j)(1); 1§ T(o)(1)].
© Dearborn Real Estate Education, 2005 Home Equity Calculation Fair Market Value$150,000$100,000 Acquisition Debt–100,000– 75,000 Home Equity$50,000$25,000 Option 1 HomeOption 2 Home
© Dearborn Real Estate Education, 2005 Home Equity Calculation Fair Market Value$75,000$75,000 Acquisition Debt–45,000– 45,000 Business Loan–25,000–0.00 Automobile Loan– 5,000–15,000 Home Equity$0$15,000 Option 1 HomeOption 2 Home
© Dearborn Real Estate Education, 2005 General Requirements for Home Mortgage Interest and Points Anything paid as compensation for the use of money is called interest. Taxpayers may deduct interest only in the year in which the interest represents a cost of using the borrowed money. Points are viewed as a substitute for a higher-stated interest rate and therefore may be deducted over the loan term [§461(g)]. Some expenses are deductible points and some are not. Uniform Settlement Statement, HUD Form 1, designates the amounts as “points” incurred to procure the loan; points must be stated as a percentage of the principal amount borrowed; the amount must be paid directly by the taxpayer.
© Dearborn Real Estate Education, 2005 Taxation of Profit— How Gains or Losses Are Computed Learning Objectives Explain the gain or loss formula; Identify items that may be included in the selling price; List items that may (or may not) be used as selling expenses; Explain adjusted basis and why correct determination is valuable in determining gain (or loss); and Summarize the differences between repairs and capital improvements and how this test applies differently to rental properties and personal residences.
© Dearborn Real Estate Education, 2005 Gain or Loss Formula SALES PRICE Selling Expenses Net Selling Price NET GAIN (or Loss) ON SALE: + – + ORIGINAL COST (or Basis) + + – Improvements Accum. Deprec. Adjusted Basis – = =
© Dearborn Real Estate Education, 2005 Gain or Loss Calculation NET SELLING PRICE NET GAIN (or Loss) ON SALE: + ORIGINAL COST (or Basis) + + – Improvements Accum. Deprec. Adjusted Basis – 45,000 20, = 25,000 =
© Dearborn Real Estate Education, 2005 Gain or Loss Calculation SALES PRICE Selling Expenses Net Selling Price NET GAIN (or Loss) ON SALE: + – + ORIGINAL COST (or Basis) + + – Improvements Accum. Deprec. Adjusted Basis – 245,000 23, ,800 = 20, , ,000 51,800 = SELLER’S COST SHEET Commission$17,150 Title Insurance 450 Attorney’s Fee 300 Accountant’s Fee 200 Origination Fee 4,900 Closing Costs 200 Total Selling Exp$23,200
© Dearborn Real Estate Education, 2005 Gain or Loss Calculation SALES PRICE Selling Expenses Net Selling Price NET GAIN (or Loss) ON SALE: + – + ORIGINAL COST (or Basis) + + – Improvements Accum. Deprec. Adjusted Basis – 245,000 23, ,800 = 20, ,000 16, ,864 67,936 = DEPRECIATION 1995 DEDUCTION$ 5, DEDUCTION$ 5,549 Total Selling Exp$16,136
© Dearborn Real Estate Education, 2005 Deductible Selling Expenses Real estate sales commissions Points paid by the seller to the buyer’s lending institution Attorney and accountant’s fees Settlement charges Closing fees Appraisal fees Advertising Escrow fees Abstract or title search Title examination Title insurance binders Title insurance Title certificate (Torrens) and registration Document preparation Recording fees Transfer tax stamps Survey Pest inspection
© Dearborn Real Estate Education, 2005 Original Cost v. Basis Usually, original cost is the cash transferred and/or received at the time of purchase. However property is frequently transferred on a non-cash basis: Inheritance Gifts Spousal Transfers Exchanges
© Dearborn Real Estate Education, 2005 Adjusted Basis Computation = – – + Purchase Expenses Construction / Rehab. Costs Capital Improvements †1 Special Assessments †2 Depreciation (prior years) Casualty Losses (if any) + Demolition Losses †3 Original Purchase Price (or Basis) – †1 Subsequent to initial acquisition or construction †2 Streets, sewers, etc. (principal only) †3 If any, per [§1.165(a)(1)]
© Dearborn Real Estate Education, 2005 Exclusion Rule for Gain on Sale of Principal Residence Learning Objectives Define principal residence; Explain when the gain realized on the sale or exchange of a principal residence is free; Identify the tax planning ideas that have been replaced (i.e., 24-month rollover and over-55 one-time exclusion); Summarize the §121 requirements to exclude up to $250,000, or $500,000 if married filing jointly, from gross income; and Explain what happens when one spouse qualifies and the other does not.
© Dearborn Real Estate Education, 2005 What Is the Definition of a Principal Residence? 1.Types of qualified properties 2.Ownership requirements 3.Occupancy requirements 4.Residences used also for business
© Dearborn Real Estate Education, 2005 Principal Residence A taxpayer’s principal residence is the land and the building where the taxpayer principally domiciles. When more than one home is owned, principal residence is home where taxpayer spends the “majority of time” Only one “principal residence” per taxpayer Each spouse may be able to separately exclude $250,000 as long as each satisfied all of the qualification requirement Personal residence may be single-family house, condominium, cooperative, mobile home, boat, houseboat, house trailer, or motorhome.
© Dearborn Real Estate Education, 2005 What Are the §121 Qualification Requirements? If the taxpayer meets both qualifications, up to $250,000/$500,000 MFJ of gain may be excluded from gross income [§121(b)(1) and (2)]
© Dearborn Real Estate Education, 2005 What Are the §121 Qualification Requirements? 1. Own and occupy for two years: The taxpayer must own and use the home as his or her principal residence for a total of two years during the five-year period ending on the date of the sale or exchange [§121(a) with three notable exceptions)
© Dearborn Real Estate Education, 2005 What Are the §121 Qualification Requirements? 2. No more than once every two years: During the two-year period ending on the date of sale, the taxpayer cannot report another sale or exchange to which §121 applies [§121(b)(3)].
© Dearborn Real Estate Education, 2005 What if a Homeowner Can’t Meet the Two-Year Rule? Sale or exchange by reason of change in place of employment Sale or exchange by reason of health Sale of exchange by reason of unforeseen circumstances –Relating to physical structure –Unforeseen circumstances as safe harbors
© Dearborn Real Estate Education, 2005 Applying the Passive Loss Rules to Real Estate Professionals Learning Objectives Explain RREAs (rental real estate activities) Summarize requirements for material participation in rental activities; Discuss the three common tests to define material participation for real estate investors; and List at least three types of taxpayers who will benefit from the 50% participation and 750-hours requirements.
© Dearborn Real Estate Education, 2005 Material Participation There are seven tests, although most real estate investors meet the “materially” participating rule by one or more of the first three tests.
© Dearborn Real Estate Education, 2005 Managing and operating the rental real estate activity for more than 500 hours during the year. Doing substantially all the work required to manage and operate the rental real estate during the year (probably more than 70% of the total business hours are performed by the landlord. Working more than 100 hours during the year with no one (including nonowner employees and independent managers) participating more than the landlord [Reg. § T (a)(1)- (3)]. However, an owner can “tack” a spouse’s time for calculating the tests mentioned above (e.g., an owner/investor performing 51 hours could add a spouse’s time of 50 hours to exceed the 100-hour requirement) [Reg. § T(f)(3)]. Working 500 hours in all the multiple small businesses owned. This is for the taxpayer who has his or her fingers in many pies. Material Participation
© Dearborn Real Estate Education, 2005 Materially participate for five of the last ten years. The years do not have to be consecutive, and only the 500-hours rule (test 1) may be used [Reg. § (j)]. Materially participate in any three previous years in “personal service activity.” These could be in the field of health, law, engineering, architecture, etc. [§ T(a)(6); also § T(d)]. “Facts-and-Circumstances” test. A taxpayer who does not satisfy any of the previous six tests may try to convince the IRS that he or she is materially participating (or not materially participating if he or she wants the income determined passive) based on all the facts and circumstances. One would have to prove participation on a “regular, continuous, and substantial basis.” Material Participation
© Dearborn Real Estate Education, % Test. More than 50% of the individual’s personal services during the tax year must be performed in real property trades or businesses in which the individual materially participated (deemed previously). and Hour Test. The individual must perform more than 750 hours of service in those same trades or businesses. Establishing Involvement in a Real Estate Business
© Dearborn Real Estate Education, 2005 Office-in-Home Rules Learning Objectives Summarize the three criteria to establish an office-in-home deduction; Define principal place in business; Discuss which transportation costs may be converted to business mileage; Cite examples of direct and indirect expenses that are used to calculate the office-in-home deduction; and Calculate the office-in-home deduction.
© Dearborn Real Estate Education, 2005 To qualify for the home-office deduction, the portion of a home that is used for business must meet all of the following three criteria: What Are the Office-in-Home Requirements? 1.It must be used exclusively for business. 2.It must be used on a regular basis for business activity. 3.It must be principally used for at least one of the following business activities: a.As the principal place of business for any trade or business conducted by the taxpayer; or b.As a place of business for meeting or dealing with patients, clients, or customers in the ordinary course of business; or c.In connection with the taxpayer’s trade or business if the taxpayer is using a separate structure that is not attached to the dwelling [§280A(c)1].
© Dearborn Real Estate Education, 2005 The exclusive use requirement does not apply when the home is used for: Exclusive Rule Exceptions 1.Day care of children, handicapped, or the elderly. 2.Wholesale or retail sellers regularly storing inventory in the home. [§280A(c)(4); §280A(c)(2); §1.280A-2(e) ].
© Dearborn Real Estate Education, 2005 What Are the Two Tests for Principal Place of Business? 1.The home office is used by the taxpayer for administrative or management activities of any trade or business of the taxpayer and 2.There is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.
© Dearborn Real Estate Education, 2005 Office-in-Home Deduction Calculation Casualty Losses Mortgage Interest Property Taxes Insurance Utilities Repairs & Maintenance Janitor or Maid Service Depreciation (39 years) Mortgage Interest Total ExpensePersonal Use Sched. A* Deduction % % % = = = %= Business Use Home Office Deduction† Total Expenses * Deduct on Schedule A, Personal 1040† Subject to §280A9(c)
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