Tax Consequences of Home Ownership PDF

Because learning changes everything. ® Modified by Dr Campbell Chapter 14 Tax Consequences of Home Ownership © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the pr...

Because learning changes everything. ® Modified by Dr Campbell Chapter 14 Tax Consequences of Home Ownership © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  KNOW ALL OF THESE ITEMS! 1 1. Determine whether a home is considered a principal residence, a residence (not principal), or a nonresidence for tax purposes. 2. Compute the taxable gain on the sale of a residence. 3. Determine the amount of the home mortgage interest deduction. 4. Discuss the deductibility of real property taxes. 5. Explain the tax issues and consequences associated with rental use of a principal residence/second home. 6. Explain the ‘limitations’ on home office-use deductions. © McGraw Hill LLC 2  Tax Status of Dwelling Unit 1 Dwelling unit includes: Home. Condominium. Mobile home. Boat. Other similar property. Dwelling unit may be used for: Solely personal use. Mixture of personal use and rental use. Solely rental use. © McGraw Hill LLC 3  Tax Status of Dwelling Unit 2 Whether a dwelling unit is a residence or nonresidence for tax purposes depends on how the unit is used. A dwelling unit is a residence if: Personal-use days are more than the greater of: 14 days, or 10 percent of the number of rental days during the year. Otherwise, it is a nonresidence for tax purposes. © McGraw Hill LLC 4  Tax Status of Dwelling Unit 3 Personal-use days include: Days taxpayer (owner) or other owner stays in the home. Days a relative of owner stays in the home even if relative pays full fair market value rent (unless home is relative’s principal residence). Days a nonowner stays in the home under vacation home exchange or swap. Days a taxpayer rents out property for less than fair market value. © McGraw Hill LLC 5  Tax Status of Dwelling Unit 4 Rental days include: Days when taxpayer rents property at FMV. Days spent repairing or maintaining home for rental use. Days that the home is available for rent but is not rented out are neither personal nor rental days. Is a residence a “principal” residence? You must consider: Amount of time taxpayer spends at each residence. Proximity of each residence to place of employment. Principal place of abode (living and sleeping) of taxpayer’s immediate family. Taxpayer’s mailing address for bills and correspondence. © McGraw Hill LLC 6  Tax Status of Dwelling Unit 5 For a given year, a dwelling unit may be a: Principal residence, Residence (not principal), or Nonresidence (rental property). © McGraw Hill LLC 7  Tax and Nontax Considerations Nontax consequences of home ownership. Large investment. Potential for big return (or loss) on investment with use of leverage. Risk of default on home loan. Time and costs of maintenance. Limited mobility. Tax consequences of home ownership. Interest expense deductible (within limits). Gain on sale excludable (within limits). Real property taxes on home deductible (within limits) Rental and business-use possibilities. © McGraw Hill LLC 8  Sale of Personal Residence Typically, gain or loss recognized on the sale of personal residence is capital gain or loss. Because a personal residence is a “personal-use asset,” any loss recognized on disposition of a personal residence is not deductible. Part or all of the gain might be excluded if the taxpayer meets certain requirements. © McGraw Hill LLC 9  Exclusion - KNOW Maximum exclusion. $500,000 for married filing jointly taxpayers. $250,000 for other taxpayers. Gain in excess of exclusion. Generally taxed as long-term capital gains. Subject to preferential rates. Must meet ownership and use tests to qualify for exclusion. © McGraw Hill LLC 10  Ownership Test - KNOW The taxpayer must have owned the property for a total of two or more years during the five-year period ending on the date of sale. For married taxpayers, either spouse can satisfy this requirement. This requirement is meant to prevent a taxpayer from buying a home, fixing it up, and soon thereafter selling it and excluding the gain. © McGraw Hill LLC 11  Use Test - KNOW The taxpayer must have used the property as the taxpayer’s principal residence for a total of two or more years during the five-year period ending on the date of sale. If married, both spouses must satisfy this requirement to qualify for the married filing jointly increased amount of $500,000. This requirement is meant to ensure that taxpayers are selling homes they actually lived in instead of investment property. © McGraw Hill LLC 12  Gain Exclusion Example 1 When Tyler and Jasmine were married, Jasmine moved into Tyler’s home located in Denver, Colorado. Tyler had purchased the home two years before the marriage. After the marriage, the couple lived in the home together as their principal residence for four years before selling the home to move to Chicago. Tyler was the sole owner of the home for the entire six years he resided in the home. Would gain on the sale of the home qualify for the $500,000 exclusion available to married couples filing jointly, even though Jasmine was never an owner of the home? © McGraw Hill LLC 13  Gain Exclusion Example Solution 1 Answer: Yes. Gain on the sale qualifies for the full $500,000 exclusion available to married couples filing jointly because Tyler met the ownership test, and both Tyler and Jasmine met the use test. © McGraw Hill LLC 14  Exceptions to General Exclusion Rules (SPECIFICS ARE NOT TESTABLE) 1 Nonqualified use limitation. Applies if taxpayer has nonqualified use of home on or after January 1, 2009. Nonqualified use includes time the home is not the taxpayer’s principal residence. Nonqualified use period does not include any portion of the five-year period ending on the date of sale that is after the last date the property was used as principal residence by taxpayer or taxpayer’s spouse. Amount of realized gain eligible for exclusion is reduced by the ratio of nonqualified use divided by the period of time the taxpayer owned the home. © McGraw Hill LLC 15  Exceptions to General Exclusion Rules - KNOW Unforeseen circumstances. If the taxpayer is required to sell before ownership/use requirements are met because of employment, health, or unusual circumstances, the exclusion is still available but the maximum exclusion is reduced. $500,000 (MFJ) or $250,000 (other taxpayers) × months taxpayer meets the ownership ∕ use requirements ∕ 24 months). © McGraw Hill LLC 16  Gain Exclusion Example for unforeseen (short-period) exception! Assume that when the Jeffersons moved from Denver, they purchased a home in Chicago for $375,000 and moved into the home on July 1, 2023. In January of 2024, Tyler accepted a work opportunity in Miami, Florida. On February 1, 2024, the Jeffersons sold their home for $525,000 and permanently relocated to Miami. How much of the $150,000 realized gain ($525,000− $375,000) on their home sale would the Jeffersons recognize? At what rate would the gain be taxed? © McGraw Hill LLC 17  Gain Exclusion Example Solution 2 Answer: $4,167 short-term capital gain (taxed at ordinary rates) [$150,000 gain realized minus $145,833 exclusion (see below)]. Exclusion computation for seven months: $500,000 (Max full exclusion) × 7 (qualifying months) / 24 = $145,833 © McGraw Hill LLC 18  Home Mortgage Interest Deduction Taxpayers are allowed to deduct home mortgage interest on a limited amount of acquisition indebtedness. Acquisition indebtedness: Debt to acquire, construct, or substantially improve the residence. Deductible as an itemized deduction. © McGraw Hill LLC 19  Limitations on Home Mortgage Interest Expense Deduction Acquisition indebtedness limit. For debt incurred before December 16, 2017, the principal loan balance limit is $1,000,000 ($500,000 MFS). For debt incurred after December 15, 2017, the principal loan balance limit is $750,000 ($375,000 MFS). A loan secured by the home that is used to substantially improve the home is considered to be acquisition indebtedness for tax purposes, even if the lender calls the loan a “home equity loan.” © McGraw Hill LLC 20  Points Usually a home buyer arranging financing pays “points.” Each point is 1 percent of the principal amount. Points paid for specific services (appraisal fees or notary fees) are not tax deductible. Points paid to reduce the interest rate (discount points) and points paid for loan origination fees are generally deductible. Discount points paid on refinancing a home loan are generally not immediately deductible by the homeowner. Must be amortized and deducted over life of loan. © McGraw Hill LLC 21  Points Example Assume that on January 1, Tyler and Jasmine bought a $300,000 home, financing the whole purchase price over 30 years. They paid two points to get a lower interest rate. How many of the points can they deduct in the current year? How many of the points could they deduct in the current year if they had paid two points to refinance their home? © McGraw Hill LLC 22  Points Example Solution $6,000 $300,000 .02 . They can deduct all the points in the first tax year because the points were paid in the initial year of acquisition of the home. $200 $6,000 / 30  per year. They are allowed to deduct the interest on the refinance over the life of the 30-year loan. © McGraw Hill LLC 23  Real Property Taxes Owners of real property generally have to pay property taxes. Generally, taxpayers pay their property taxes through escrow. A holding account with the lender. Each monthly payment includes approximately 1 ∕ 12 of the annual property taxes. The taxpayer gets a deduction when the property taxes are actually paid to the jurisdiction. When property is sold during the year, the buyer and seller deduct the taxes for the portion of the year that they owned the property. $10,000 overall limit on itemized deduction for taxes, including real property taxes. © McGraw Hill LLC 24  Rental Use of the Home Three types of classifications for second home: 1. Residence with minimal rental use (rented for 14 or fewer days). (Important to know for your TAX RETURN PROJECT) 2. Residence with significant rental use (rented for 15 or more days). 3. Nonresidence. © McGraw Hill LLC 25  Residence with Minimal Rental Use The taxpayer must live in the home for at least 15 days and rent it out for 14 days or fewer. Rental income can be excluded. No rental expenses deducted except those that are itemized deductions relating to the home (home mortgage interest and real property taxes). © McGraw Hill LLC 26  Residence with Significant Rental Use (Vacation Home) Rent home for 15 days or more. Personal use, greater of. 14 days. 10 percent of the number of rental days. Include rental revenues in gross income and allocate expenses between personal use and rental use. © McGraw Hill LLC 27  Nonresidence (Rental Property) 2 The taxpayer includes all income and deducts all rental expenses. However, if the property is used for even a day of personal use, the expenses must be allocated between rental usage and personal usage. The taxpayer is not allowed to deduct the personal use portion of the mortgage interest expense because the property doesn’t qualify as a residence. The personal use portion of real property taxes (subject to limitation) are deductible as an itemized deduction (from A GI). © McGraw Hill LLC 28  Losses on Rental Property Losses on rental property are generally considered to be passive activity losses (PALs). ’ PALs can only be deducted to the extent the taxpayer has ’ passive activity income (net rental income is passive income). $25,000 rental real estate exception (known as Mom & Pop exception). May deduct as ordinary nonpassive loss. Must be active participant in rental activity. $25,000 amount is phased out 50 cents for every dollar of AGI in excess of $100,000 (phased out completely at AGI of $150,000). © McGraw Hill LLC 29  Business Use of the Home: Home Office Expense Deduction To qualify for a “home office” deduction, a taxpayer must use her home or part of her home exclusively and regularly as either: The principal place of business for any of the taxpayer’s trade/business, or A place to meet with patients/clients in the normal course of business. © McGraw Hill LLC 30  Home Office Expense Deduction Only for self-employed taxpayers. Deducted for AGI; but deduction limited to business income before the deduction. Actual expense method versus simplified method. (You must use the ‘simplified method on your tax return project) © McGraw Hill LLC 31  Home Office Expense Deduction: Actual Expense Method 1 Must allocate actual expenses between personal and business use of home. Direct versus indirect expenses. Indirect expenses (examples: A/C & water) allocated based on square footage. © McGraw Hill LLC 32  Home Office Expense Deduction: Actual Expense Method 2 Deduction is limited to gross income derived from business use of the home (Schedule C net income minus business expenses unrelated to use of home). Depreciation expense (important facture to consider!) Reduces basis in home. Gain on sale due to depreciation is ineligible for exclusion. Gain is taxed at a maximum 25 percent rate as unrecaptured n o i t c e S §1250 gain. © McGraw Hill LLC 33  Home Office Expense Deduction: Simplified Method 1 Deduct square footage (limited to 300 square feet) × $5 per square foot application rate. Maximum deduction is $1,500 no matter how large the office or how much the expense. Limited to Schedule C net income minus business expenses unrelated to the home. No depreciation expense. Excess expenses do not carry over. Can choose each year whether to use simplified or actual expense method. © McGraw Hill LLC 34  Best wishes studying this week… Exam 2 is just around the corner! This Photo by Unknown Author is licensed under CC BY-SA © McGraw Hill LLC 35