Wild Taxes for Homeowners (Part 2)

On July 23rd I had the pleasure of hosting Part 2 of The Wild Taxes Small Business Edition Zoom series with one of my good friends, Amber Carter (IG:@closewithcarter). We discussed strategies and tax implications for homeowners.  If you weren't able to join, I've got you covered. See below for a recap.

**The information in this post is intended to be general, not tax or legal advice. Always consult with your tax specialist or financial advisor prior to making any tax or financial decisions.

Planning for a home purchase:

• Credit – Certain loans and first-time homebuyer grants require minimum credit scores. Credit score can affect your interest rate and loan approval amount.

• Down Payment – First time homebuyers can put down as low as 3% towards down payment.

• Closing Costs – Factor in closing costs when considering a home purchase. Generally closing costs are around 2%-5% of the cost of the home.

• Location/Market – Always take into consideration location and market when deciding on a home purchase. What location is optimal for your needs? Close to transportation? Good school system? Close to a local college/university for renting? Opportunity zone?

• Inspection – Perform proper due diligence about a property prior to purchasing.

Calculating Gain/Loss:

Yolanda purchased her first property in 2016 on MLK Blvd. After living in the home for 3 years Yolanda was able to purchase a new home downtown in 2019. Yolanda has been renting the property on MLK Blvd for a year. However, due to covid-19 Yolanda’s tenant stopped paying rent. It is now July 2020 and Yolanda can’t keep up with both mortgage payments, so she is thinking about selling the property on MLK Blvd. Yolanda makes $65K a year and is concerned that she will have to pay a large sum in taxes and closing costs.

• Yolanda purchased the home on MLK Blvd for $200k back in 2016. In July 2020, Yolanda sells the home for $225k. Her Realized gain is $25k ($225k-$200k).

• Back in 2017, Yolanda built a deck on the property for $10k, increasing her basis to $210k. Her taxable gain is reduced to $15k ($225k-$210).

• Additionally, Yolanda paid $5k in closing costs. Her taxable gain is reduced to $10k ($15k-$5k).

IRS Guidance – Publication §523

First $250k ($500k if married) gain from a home sale is tax free if:

• Lived and owned the home for 2 of the 5 years prior to the sale

• Haven't claimed the exclusion on another home in the last two years.

• Did not acquire the property through a like-kind exchange (1031 exchange) during the past 5 years

• You are not subject to expatriate tax

You may still qualify for the deduction if the home sale was due to a change in workplace location, a health issue, or an unforeseeable event.  However, losses from a home sale cannot be deducted from income.

Using the same example from above, Yolanda is eligible for the §523 tax deduction because she lived in the home for 2 of the 5 years prior to the sale. She will pay $0 in taxes on the $10k taxable gain.

If she was not eligible for the deduction, then she would pay capital gains taxes on the $10k gain.  Since Yolanda's taxable income is $75k ($65k+$10K) she will 15% taxes on the $10k gain or $1,500.

Capital gains tax rates are:

• 0% - income < $40,000 ($80,000 if married)

• 15% - income < $441,500 ($496 if married)

How much did Yolanda really make?

Assume Yolanda purchased the home for $200k in 2016. By the time she sells the home in 2020, her mortgage balance is $185k.  After closing costs, her net cash proceeds are $35k cash ($225k-$185k-5k) even if her taxable gain is only $10k.

• Since her taxable income is $75k ($65k+$10K) she will only owe $1,500 in taxes even if she was not eligible for the §523 tax deduction.

• However, if Yolanda had earned $35k as salary/wages she would have paid approx. $8,750 in taxes assuming an effective tax rate of 25%.

Like-kind Exchange (Section 1031)

Section 1031 allows taxpayers to dispose of property and subsequently acquire one or more other like-kind replacement properties without paying taxes on any potential gain.

• Only applies to investment property (not personal property).

• You have 45 days from the date you sell the relinquished property to identify a potential replacement property. It must be in writing, signed by you and delivered to the seller of the replacement property or the qualified intermediary. (Notice to your attorney, real estate agent, accountant, etc. is not sufficient)

• The exchange must be completed no later than 180 days after the sale of the exchanged property or before the tax return due date (including extensions).

• Keep your agent/lender informed if you decide to do a section 1031 exchange because there are certain requirements and steps to take.

• Work with your tax professional on calculating the basis of the new property.