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Home Ownership & Taxes

Taxes. I've never met anyone who enjoyed paying taxes!  Taxes seem to be one item that we'd all rather avoid.  Home ownership can impact the amount of taxes that we pay. So ... If you're thinking of buying or selling a home ... You'd be well advised to consider the Tax Implications of your transaction!

Tax Advice. I'm not a Tax Attorney or an Accountant ... I'm a Realtor.  So ... Let me caution you that I'm not equipped to give you Tax Advice!  And ... Before relying on this information, you should seek advice from a tax professional!  That said ... I'd like to pass on some information that could increase your Awareness of Tax Issues in the area of Home Ownership. 

Real Property Tax. Most homeowners pay property taxes to the town, city or county where their property is located.  In most situations the monthly mortgage payment collects money for property taxes.  The mortgage company holds these funds in an escrow account, and actually pays the taxes (for the homeowner) when they're due.  The mortgage company normally provides the homeowner an annual notice of the amount of property taxes paid.  While the property tax rates charged by towns, cities and counties vary ... Typical rates in Northern Virginia are in the neighborhood of 95 cents per year for every $100 of a home's assessed value.  For example ... A home valued at $400,000 might have an annual property tax bill of $3,800 ($400,000 x .95%).

Residence Related Tax Deductions. If a homeowner chooses to Itemize Deductions on their Federal and State Income Tax submissions, the amounts paid for property tax and mortgage interest on a primary residence will normally form the basis of an Itemized Deduction.  So ... If a homeowner paid $14,000 in mortgage interest and $3,800 in property taxes, the total deduction ($17,800) could produce an annual Income Tax Avoidance in the range of $4,000 to $7,000 based on their income level and tax rate. Consequently, homeowners enjoy ongoing tax benefits that are not applicable when renting a primary residence.

Sale of Residence Tax Exclusion. In 1997 The Federal Tax Laws concerning the sale of a primary residence underwent substantial change.  Under the Taxpayer Relief Act of 1997, a homeowner can exclude gains made on the sale of their primary residence of up to $250,000 individually or $500,000 jointly if certain conditions are met.  To qualify the homeowners must have resided in the home as their primary residence for at least 2 of the past 5 years and not have claimed a home sale tax exclusion within the past 2 years.  Unlike before 1997, there are no requirements that the sale proceeds be reinvested in housing and no homeowner age restrictions.

You'll notice that to qualify you need to have used the home for 2 of the past 5 years.  So ... If you lived in a home for at least 2 years and then rented it out for the next 2 to 3 years ... You could still claim the Tax exemption for the gain (up to $250k/$500k).  However ... Separate rules could apply for a portion if you had claimed depreciation while renting it out.

 Lastly ... You can repeat the tax exclusion every 2 years!  Yes ... You can claim this exemption more than once in a lifetime ... Unlike the law prior to 1997, you can claim it for sequential sales of primary residences every two years.

Section 1031 Tax Deferrals. The above discussion of Tax Exclusion dealt with the sale of your primary residence.  What if we're talking about the sale of rental property or real property held for investment.  While you've likely heard of the term Capital Gains Tax ... You may not be familiar with the concept of deferring Capital Gains Tax with a Section 1031 Exchange or a Starker Exchange.  The current tax law provides a vehicle to let you to defer paying Capital Gains tax on the sale of rental property if you 'Exchange' the property for 'Like Kind' property of equal or greater value ... And ... Reinvest all of the proceeds of the sale (of the 1st property) in the purchase (of the 2nd property).  As you'd expect ... There's a pretty heavy set of tax rules to successfully navigate a Capital Gains Tax Deferral.  So ... Here's a brief summary of what's required.

You need an Intermediary ... You can't Touch the Money ... Before Closing the sale of your rental property you'll need to appoint a qualified intermediary to hold your sale proceeds in escrow. (They're facilitating your Exchange of Property A for Property B.)

You must Identify the New Property within 45 Days of Closing the Sale of the Old Property ... You need to declare the specific property you're going to buy (exchange for) within 45 days of your initial sale closing ... You can identify up to 3 specific properties.  If you miss the 45 day deadline ... The Exchange is off and you'll need to consider any gain from the previous sale as taxable.

You must Close the Purchase Transaction within 180 Days of the previous Sale Closing ... You need to close the purchase of 1 or more of the identified properties within 180 days of the initial sale's closing ... Miss the 180 days ... Buy a different property ... The Exchange is off and you'll need to consider any gain from the previous sale as taxable.

You must Reinvest All of the Cash From the Sale ... If you use less cash in the purchase of the exchanged property ... You may have only partially exchanged ... And you may need to consider any left over cash from the previous sale as taxable Capital Gains.

If the 'Exchanged' Property had a Mortgage, You Must Employ At Least as Large a Mortgage on the new property ... If you use a smaller mortgage in the purchase of the exchanged property ... You may have only partially exchanged ... And you may need to consider the mortgage difference from the previous sale as taxable Capital Gains.

The bottom line is that a favorable exchange involves a purchase of equal or greater value ... Employing an equal or greater amount of Cash ... And an equal or greater Mortgage.

Like to 'Read-up' on the subject of Section 1031 'Starker' Exchanges?  Here's a few links to additional discussion ...
1031 Exchange Manual 
Nat'l Association of Realtors 1031 Exchange Field Manual
Starker Services 

Sounds Hard ... Why Bother?  Easy answer ... To move from one investment property to the next while deferring Capital Gains Tax until later ... Or even Never!  A similar principle to that of an IRA Account or a 401K ... But ... Involving Real Estate.  Also ... Under today's rules ... You can drive your property exchanges toward the eventual purchase of an investment property that you convert to a primary residence ... And eventually sell that property under the Tax Exclusion rules that apply to Primary Residences.  Food for thought!

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