Vacation Homes Under Today’s New Tax Rules – Part II

Tax-Free Sale of Vacation Home

In many cases, the profitable sale of a vacation home will result in tax-favored capital gain, although the gain will be subject to the 3.9% surtax on unearned income. However, some taxpayers may be able to sell their vacation homes and wind up with a profit that’s partially or completely tax-free. Tax-free profits are possible where a taxpayer sells his or her regular home (e.g., at retirement), moves into what had been the taxpayer’s vacation home, and uses that property as his or her principal residence. If the vacation home is later sold, gain on the vacation home, as well as one the sale of the prior main home, is eligible for the up-to-$250,000 exclusion ($500,000 for qualifying married taxpayers) if each is owned and used as a principal residence for at least two of the five years preceding the sale date of each home, and two years elapse between the sales. (Code Sec. 121(a), Code Sec. 121(b)(3))

Note that under Code Sec. 121(c), a reduced maximum exclusion may apply to taxpayers who

1. Fail to qualify for the 2-out-of-5-year ownership and use rule, or

2. Previously sold another home within the 2-year period ending on the sale date of the current home in a transaction to which the exclusion applied.

That reduced maximum exclusion rule applies if the taxpayer’s failure to meet either rule occurs because he or she must sell the home due to a change of place of employment, health, or to the extent provided by regs, other unforeseen circumstances. Additionally, that part of the gain attributable to depreciation claimed on the vacation home for post-May 6, ’97 periods isn’t eligible for the exclusion. (Code Sec. 121(d)(6))

Reduced homesale exclusion for nonqualified use. The Code Sec. 121(a) rule excluding homesale gain if the 2-out-of-5-year rule is met does not apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. (Code Sec. 121(b)(5)) Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse. For example, use of a residence as a vacation home or as rental property is nonqualified use.

Observation:  It’s important to note that the exclusion isn’t reduced for nonqualified use; rather, it’s the gain potentially eligible for the exclusion. Thus, if the homesale gain is large enough, the seller may be able to use the full homesale exclusion despite extensive periods of nonqualified use.

Illustration:  A single taxpayer buys a residence this year, uses it as a vacation home for four years, and then uses it as a principal residence for four years. He owns no other residences. If he subsequently sells the home and realizes a gain of $500,000, half of the gain will be allocable to nonqualifying use and subject to tax as long-term capital gain (and the 3.9% surtax on unearned income), but the other half will qualify for the full $250,000 homesale exclusion.

The amount of gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction

1. The numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, and

2. The denominator of which is the period the taxpayer owned the property. (Code Sec. 121(b)(5)(B))

For determining the amount of gain allocated to nonqualified use of a principal residence:

• The rule providing that gain allocated to periods of nonqualified use does not qualify for the exclusion is applied after the application of Code Sec. 121(d)(6) (i.e., rules providing that gain attributable to post-May 6, ’97 depreciation does not qualify for the exclusion), and

• The rules providing for the allocation of gain to periods of nonqualified use are applied without regard to any gain to which Code Sec. 121(d)(6) applies. (Code Sec. 121(b)(5)(D))

Tax-Deferred Exchange of Vacation Home

The Tax Cuts and Jobs Act of 2017 (TCJA; P.L. 115-97, 12/22/2017) included a major crackdown on like-like exchanges. Generally effective for transfers after Dec. 31, 2017, the Code Sec. 1031 rule permitting tax to be deferred when property is exchanged for property of a like-kind that also is held for productive use in a trade or business or for investment, applies only with respect to real property that is not held primarily for sale. (Code Sec. 1031(a)(1)) Fortunately, vacation homes still may be eligible for tax-deferred exchanges. That’s true despite the well-settled rule that personal residences can’t be exchanged tax-free under Code Sec. 1031 because they aren’t held for productive use in a trade or business or for investment.

Under Rev Proc 2008-16, 2008-1 CB 547, a safe harbor applies under which a dwelling unit (real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities) will qualify as property held for productive use in a trade or business or for investment for Code Sec. 1031 purposes even though it is occasionally used for personal purposes.

More specifically, under Rev Proc 2008-16, IRS won’t challenge on personal use grounds whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of Code Sec. 1031 if:

1. The taxpayer owns the property for the qualifying use period (for relinquished property, at least 24 months immediately before the exchange; for replacement property, at least 24 months immediately after the exchange); and

2. Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange (in the case of relinquished property) or immediately after the exchange (in the case of replacement property),

i. The taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and

ii. The period of the taxpayer’s personal use of the dwelling unit doesn’t exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

For relinquished property, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months before that day), and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months before that day). For replacement property, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

Illustration:  Tina owns a beach condominium (relinquished property) that she intends to exchange in a tax-free like-kind exchange for a lake house (replacement property). Tina has owned the condominium for five years before the exchange. During each of the two 12-month periods immediately preceding the exchange, she used the condominium for personal purposes for 16 days and rented it at fair rental for 163 other days. She meets the 14-or-more rental days requirement, and the number of days on which she used the condominium for personal purposes (i.e., 16) doesn’t exceed 16.3 (10% of 163, the number of other days on which the home is rented at a fair rental). Thus, Tina’s personal use of the condominium also meets the use test for purposes of the safe harbor.

If she also satisfies the safe harbor’s ownership and usage periods for the lake house (replacement property), the swap transaction will be treated as a like-kind exchange (assuming all the other conditions are satisfied) even if Tina subsequently uses that property strictly as a personal residence.

Personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under Code Sec. 280A(d)(2) (taking into account Code Sec. 280A(d)(3) but not Code Sec. 280A(d)(4)).

Observation:  Code Sec. 280A(d)(2) provides a safe harbor under which a taxpayer is treated as using a dwelling unit for personal purposes for a day if the unit is used for personal purposes by:

1. The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;

2. Any individual who uses the unit under a reciprocal use arrangement (other than use by a person having an equity interest in the property under a shared equity financing agreement); or

3. Any individual unless for that day the dwelling unit is rented for a fair rental (an individual’s use doesn’t count if the value of the use is excludable from the individual’s gross income under Code Sec. 119). Under Code Sec. 280A(d)(3), a taxpayer is not treated as using a dwelling unit for personal reasons if the unit is rented out or held for rental at a fair rental to any person for use as a personal residence. And under Code Sec. 280A(d)(4), personal use days don’t include days the taxpayer used a dwelling unit as his principal residence:

A.  Before or after a rental (or attempted rental) period of 12 or more consecutive months beginning or ending in the tax year; or

B.  Before a consecutive rental (or attempted rental) period of less than 12 months beginning in the tax year, at the end of which the residence is sold or exchanged.

The safe harbor applies only to the determination of whether a dwelling unit is held for productive use in a trade or business or for investment under Code Sec. 1031. Thus, a taxpayer using the safe harbor also must satisfy all other requirements for a like-kind exchange under Code Sec. 1031 and the like-kind exchange regs.

Observation:  The replacement property received in the Code Sec. 1031 exchange ultimately may qualify for the home sale exclusion if the Code Sec. 121 requirements are met. However, taxpayers who received a vacation home as replacement property in a like-kind exchange should be aware that, for purposes of computing the Code Sec. 121 exemption, any rental use of the replacement property would be considered to be a period of nonqualified use for purposes of the Code Sec. 121(b)(5) rule (see above) denying the home-sale exclusion for periods of nonqualified use.

Taxpayers also should be aware that if they acquire a home in a Code Sec. 1031 exchange in which any gain wasn’t recognized, the Code Sec. 121 exclusion does not apply to the sale of the home by the taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to the basis in the hands of the taxpayer) for the 5-year period beginning with the date of acquisition. (Code Sec. 121(d)(10))

Observation:  As explained above, for purposes of the Code Sec. 121(a) exclusion, Code Sec. 121(c) provides for a reduced exclusion that applies when the taxpayer does not meet the two-year ownership and use requirements by reason of a change in place of employment, health, or unforeseen circumstances. Code Sec. 121(d)(10) doesn’t provide a comparable exception to the five-year holding period.

© 2018   Douglas Rutherford, CPA, CGMA, CPLA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

Vacation Homes Under Today’s New Tax Rules – Part I

The tax treatment of a vacation home depends on the mix of personal and rental use.  If personal use of the home is extensive enough for it to be treated as used as a residence under Code Sec. 280A, deductions for the rental portion will be restricted by the vacation home rules in that provision, but deductions for the personal use portion won’t be affected.  If there’s enough rental use for the property to be treated as rental property, not as a personal residence, then

1. The owner’s rent-related deductions will be restricted by the passive activity loss rules, not the vacation home rules, and

2. Deductions for the personal use portion will be adversely affected.

Vacation Home Used as a Residence

A vacation home is treated as used as a residence during a tax year if personal use exceeds the greater of 14 days or 10% of the days the property is rented to others during the year at a fair rental. (Code Sec. 280A(d)(1)) Although the property is considered to be a residence, the owner still must treat the rental portion of the vacation home separately from the personal portion.

Rental portion. With an exception for limited rental use noted below, rentals are included in income on Schedule E, but may be offset with deductions for the rent-related portions of expenses such as utilities, maintenance, upkeep, mortgage interest, real estate taxes and insurance. The owner also may claim a depreciation deduction relating to the rental use. However, under Code Sec. 280A(c)(5), those types of deductions can’t exceed rental income less:

1. Other deductions related to the rental activity itself, such as advertising, broker’s commissions, and cleaning fees paid by the owner after rental periods.

Observation: One example of a deduction that fits into this category is the owner’s costs to travel to his or her vacation home in connection with its rental. For example, the owner may have to drive out to the home to meet a prospective tenant, or arrange for the home to be cleaned up or repaired before the rental season begins. These types of expenses should be deductible (e.g., (54.5¢ per mile for business travel in 2018), along with other rental-related costs.

2. Deductions (such as interest and real estate taxes) allocable to the rental use which would be deductible whether or not the vacation home was rented out.

Excess expenses are carried forward and may be used in a future year when there’s additional rental income.

For any year in which the rules of Code Sec. 280A(c)(5) apply to a property, the passive loss rules don’t apply. (Code Sec. 469(j)(10))

Excess expenses are carried forward and may be used in a future year when there’s additional rental income.

For any year in which the rules of Code Sec. 280A(c)(5) apply to a property, the passive loss rules don’t apply. (Code Sec. 469(j)(10))

Personal portion. The owner deducts on Schedule A the real estate taxes and mortgage interest allocable to personal use of the home. Because personal use exceeds the greater of 14 days or 10% of the days it is rented out during the year, the vacation home is treated as a qualified residence for purposes of the mortgage interest deduction. (Code Sec. 163(h)(4)(A)(i)(II)) Assuming the taxpayer doesn’t own another vacation home and meets the other rules for deducting qualified residence interest, he or she can (subject to the limitations discussed below) deduct the personal-use portion of the year’s mortgage interest.

TCJA changes for residence interest. Under the Tax Cuts and Jobs Act (TCJA), for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the limit on acquisition debt (debt that is secured by the taxpayer’s principal home and/or a second home, or incurred in acquiring, constructing, or substantially improving the home) is reduced to $750,000 ($375,000 for a married taxpayer filing separately). The $1 million, pre-TCJA limit applies to acquisition debt incurred before Dec. 15, 2017, and to debt arising from refinancing pre-Dec. 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. (Code Sec. 163(h)(3)(F))

Additionally, under the TCJA, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, there’s no deduction for interest on “home equity debt”. The elimination of the deduction for interest on home equity debt applies regardless of when the home equity debt was incurred. (Code Sec. 163(h)(3)(F)) In IR 2018-32, IRS clarified that the TCJA suspended the deduction for interest paid on home equity loans and lines of credit unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.

Illustration.  In January 2018, Max obtained a $500,000 mortgage to buy a main home. The loan is secured by the main home. In June 2018, he takes out a $250,000 loan to buy a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. But if Max took out a $250,000 home equity loan on the main home to buy the vacation home, then the interest on the home equity loan would not be deductible.

TCJA changes for property taxes. Under the TCJA, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, annual deductions for state and local taxes (including those paid on a vacation home) are limited to a maximum of $10,000. (Code Sec. 164(b)(6))

Allocating expenses. IRS says that where a vacation home is treated as used as a residence, all expenses are apportioned between rental and personal use based on the number of days used for each purpose. (Prop Reg § 1.280A-3(d)(3)(iii) However, the Tax Court (Buchholz, TC Memo 1983-378), Ninth Circuit (Bolton v. Comm., (1982, CA9) 51 AFTR 2d 83-305), and Tenth Circuit (McKinney v. Comm., (1983, CA10) 52 AFTR 2d 83-6281) maintain that interest and taxes are allocated to rental use based on the ratio of actual rental days to total calendar days. All other expenses (e.g., utilities and maintenance) are allocated based on the ratio of rental days to total days of use.

Observation:  The approach used by the Courts mentioned above can yield bigger overall deductions for the vacation home owner. For example, if a home is rented three months a year and used by the owner for vacations for one month a year, IRS’s allocation of interest and taxes is based on the period of actual occupancy (four months), and the amount of rental income against which other expenses can be deducted is reduced by ¾ of the interest and taxes. But if interest and taxes are allocated on the basis of an entire year (as permitted by the Tax Court, Ninth and Tenth Circuits), rental income is reduced by only ¼ of the interest and taxes (3 months divided by 12 months), with the other ¾ deductible as itemized deductions. The reduction in the rental expense to only ¼ of the total can then bring about a larger deduction of other rental expenses that would otherwise be disallowed under the Code Sec. 280A(c)(5) limitation.

Special rule for limited rental use.  A taxpayer who rents out his or her vacation home for less than 15 days during the year doesn’t report rental income and can’t claim offsetting rent-related vacation home deductions. (Code Sec. 280A(g)) This one-of-a-kind tax break can be a windfall for those who own properties in prime vacation spots or in other sought-after areas (e.g., one near a prime sporting event) where even a few rental days can bring in substantial dollars.

Tax credit for residential energy efficient property installed in vacation home used as residence.  For property placed in service before 2022, an individual is allowed an annual nonrefundable personal tax credit under Code Sec. 25D for the purchase of certain residential energy efficient property. As applied to such property installed in a vacation or second home used as a residence, for property placed in service before Jan. 1, 2020, the credit is equal to the sum of 30% of the amount paid for:

1. Qualified solar electric property (i.e., property that uses solar power to generate electricity in a home)

2. Qualified solar water heating property (i.e., property to heat water for use in a home if at least half of the energy it uses is derived from the sun);

3. Qualified small wind energy property (wind turbine to generate electricity for a home); and

4. Qualified geothermal heat pump property (to heat water for use in a residence if at least half of the energy used is derived from the sun).

For property placed in service in 2020, the credit rate will be 26%; and for property placed in service in 2021, the credit rate will be 22%. (Code Sec. 25D(g))  The equipment must be installed in a dwelling unit that’s located in the U.S. and used as the taxpayer’s residence (Code Sec. 25D(d)) and can’t be used to heat a swimming pool or hot tub. (Code Sec. 25D(e)(3))

The credit covers installation and labor costs (Code Sec. 25D(e)(1)) and includes sales tax. If the equipment is used less than 80% for nonbusiness purposes, only the expenses properly allocable to nonbusiness use are taken into account. (Code Sec. 25D(e)(7))

Vacation Home Used as Rental Property

A vacation home is treated primarily as rental property for a tax year in which personal use of the unit doesn’t exceed the greater of 14 days or 10% of the days the property is rented out during the year at a fair rental. In this situation, the owner’s deductions are restricted by the Code Sec. 469 passive loss rules, not by the vacation home rules.

Rental portion. When a vacation home is treated as rental property, its income and deductions generally are automatically treated as passive in nature (unless the owner qualifies under the Code Sec. 469(c)(7) material participation exception for qualifying real estate professionals). If deductions allocable to the rental portion exceed rental income, the loss generally can only offset other passive income until the property is disposed of. However, if the owner actively participates in the vacation home rental activity, and adjusted gross income (AGI) doesn’t exceed $100,000, then he or she can shelter non-passive income with up to $25,000 of losses from active-participation real estate rental activities, including the vacation home rental enterprise. The $25,000 allowance starts to phase out when AGI exceeds $100,000, and disappears completely when AGI reaches $150,000. (Code Sec. 469(i)(3)(A))

The active participation standard, which is less stringent than the material participation requirement, can be satisfied without regular, continuous, and substantial involvement in operations as long as the taxpayer participates in a significant way by, for example, making management decisions or arranging for others to provide services. Management decisions that are relevant in determining whether a taxpayer actively participates include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions. (S Rept No. 99-313 (P.L. 99-514), 1986-3 CB 737) The $25,000 allowance won’t be available if a management or rental agent handles all aspects of renting the unit and maintaining it. See, e.g., Madler, TC Memo 1998-112.

The rules are different if the property is not treated as a rental activity under the special rules of Reg. § 1.469-1T(e)(3)(ii). For example, if the average period of customer use is seven days or less, the property will be treated as a trade or business, which means the taxpayer must be a material participant in the activity in order to claim deductions in excess of income.

Personal portion. The real estate taxes allocable to personal use of the vacation home is deductible on Schedule A, subject to the tough $10,000 annual state and local tax limitation. Additionally, since personal use does not exceed the greater of 14 days or 10% of the time the unit is rented out, the home is not treated as a qualified residence under Code Sec. 163(h)(4)(A)(i)(II). As a result, the interest paid on a mortgage secured by the vacation home, and allocable to personal use, will be treated as nondeductible personal interest.

End of Part I: Vacation homes under the new tax rules.

© 2018   Douglas Rutherford, CPA, CGMA, CPLA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

Year-End Moves to Make Light of Tax Reform Legislation

Congress appears poised to enact a major tax reform law that could potentially make fundamental changes in the way you and your family calculate your federal income tax bill, and the amount of federal tax you will pay. This letter is designed to help you cope with the changes Congress is hammering into shape right now—to take advantage of tax breaks that may be heading your way, and to soften the impact of any crackdowns. Keep in mind, however, that while most experts expect a major tax law to be enacted this year, it’s by no means a sure bet. So keep a close eye on the news and don’t swing into action until the ink is dry on the President’s signature of the tax reform bill.

The general plan of action to take advantage of lower tax rates next year would be to defer income into next year. Some possibilities follow:

• If you are an employee who believes a bonus is coming your way before year end, consider asking your employer to delay payment of the bonus until next year.

 

• If you are thinking of converting a regular IRA to a Roth IRA, postpone your move until next year. That way you’ll defer income from the conversion until next year and hopefully have it taxed at lower rates.

 

• If you run a business that renders services and operates on the cash basis, the income you earn isn’t taxed until your clients or patients pay. So if you hold off on billings until next year—or until so late in the year that no payment can be received this year—you will succeed in deferring income until next year.

 

• If your business is on the accrual basis, deferral of income till next year is difficult but not impossible. For example, you might, with due regard to business considerations, be able to postpone completion of a job until 2018, or defer deliveries of merchandise until next year. Taking one or more of these steps would postpone your right to payment, and the income from the job or the merchandise, until next year. Keep in mind that the rules in this area are complex and may require a tax professional’s input.

 

• The reduction or cancellation of debt generally results in taxable income to the debtor. So if you are planning to make a deal with creditors involving debt reduction, consider postponing action until January to defer any debt cancellation income into 2018.

Disappearing deductions, larger standard deduction. Beginning next year, both the House-passed tax reform bill and the version before the Senate would repeal or reduce many popular tax deductions in exchange for a larger standard deduction. Here’s what you can do about this right now:

• The House-passed tax reform bill would eliminate the deduction for nonbusiness state and local income or sales tax, but would allow an up-to-$10,000 deduction for real estate taxes on your home. The bill before the Senate would ban all nonbusiness deductions for state and local income, sales tax, and real estate tax. If you are an employee who expects to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding on those taxes. That way, additional amounts of state and local taxes withheld before the end of the year will be deductible in 2017. Similarly, pay the last installment of estimated state and local taxes for 2017 by Dec. 31 rather than on the 2018 due date, or prepay real estate taxes on your home.

 

• Neither the House-passed bill nor the bill before the Senate would repeal the itemized deduction for charitable contributions. But because most other itemized deductions would be eliminated in exchange for a larger standard deduction (e.g., in both bills, $24,000 for joint filers), charitable contributions after 2017 may not yield a tax benefit for many. If you think you will fall in this category, consider accelerating some charitable giving into 2017.

 

• The House-passed bill, but not the one before the Senate, would eliminate the itemized deduction for medical expenses. If this deduction is indeed chopped in the final tax bill, and you are able to claim medical expenses as an itemized deduction this year, consider accelerating “discretionary” medical expenses into this year. For example, order and pay for new glasses, arrange to take care of needed dental work, or install a stair lift for a disabled person before the end of the year.

Other year-end strategies. Here are some other “last minute” moves that could wind up saving tax dollars in the event tax reform is passed:

• The exercise of an incentive stock option (ISO) can result in AMT complications. But both the Senate and House versions of the tax reform bill call for the AMT to be repealed next year. So if you hold any ISOs, it may be wise to hold off exercising them until next year.

 

• If you’ve got your eye on a plug-in electric vehicle, buying one before year-end could yield you an up-to-$7,500 discount in the form of a tax credit. The House-passed bill, but not the one before the Senate, would eliminate this credit after 2017.

 

• If you’re in the process of selling your principal residence and you wrap up the sale before year end, up to $250,000 of your profit ($500,000 for certain joint filers) will be tax-free if you owned and used the property as your main home for at least two of the five years before the sale. However, under the House-passed bill and the bill before the Senate, the $250,000/$500,000 tax free amounts would apply to post-2017 sales only if you own and use the property as your main home for five out of the previous eight years.

 

• Under current rules, alimony payments generally are an above-the line deduction for the payor and included in the income of the payee. Under the House-passed tax bill but not the version before the Senate, alimony payments would not be deductible by the payor or includible in the income of the payee, generally effective for any divorce decree or separation agreement executed after 2017. So if you’re in the middle of a divorce or separation agreement, and you’ll wind up on the paying end, it would be worth your while to wrap things up before year end if the House-passed bill carries the day. On the other hand, if you’ll wind up on the receiving end, it would be worth your while to wrap things up next year.

 

• Both the House-passed bill and the version before the Senate would repeal the deduction for moving expenses after 2017 (except for certain members of the Armed Forces), so if you’re about to embark on a job-related move, try to incur your deductible moving expenses before year-end.

© 2017 Douglas Rutherford, CPA, CGMA, CPLA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

A review of the tax angles clients should be aware of when they consider refinancing their home loans.

With some experts predicting that home mortgage rates will rise, homeowners with adjustable-rate mortgages or higher-interest fixed rate mortgages obtained years ago may be motivated to refinance now.

Others may find that refinancing a loan to renovate or expand a home may be more cost effective than trading up to another home.

Deductions from exiting the old mortgage. Prepayment penalties are deductible as interest subject to the rules of Code Sec. 163. (Rev Rul 57-198, 1957-1 CB 94) Thus, if there’s a penalty for paying off a mortgage early, it’s fully deductible if the retired debt itself qualified as acquisition debt or home-equity debt under Code Sec. 163(h)(3). Additionally, if the borrower had to deduct points over the life of the old mortgage, the remaining unamortized portion of the points charge generally may be deducted currently as interest (again, assuming the underlying loan qualified). (PLR 8637058; IRS Publication 936, 2016, pg. 8)

However, if the mortgage loan is refinanced with the same lender, IRS says the remaining balance of capitalized points must be deducted over the term of the new loan, not in the year the prior mortgage ends. (IRS Publication 936, 2016, pg. 8)

Points on the new loan.  If the conditions of Code Sec. 461(g)(2), Reg. § 1.6050H-1(f)(1) and Reg. § 1.6050H-1(f)(2) are satisfied, points paid in connection with the purchase or improvement of a principal residence are currently deductible. IRS says that points paid on a refinance loan are deductible.

1. Only if the borrower pays the charge out of his own cash at the closing (e.g., the charge isn’t withheld from the mortgage loan), and

2. Only to the extent the proceeds are used to improve the residence. (Rev Rul 87-22, 1987-1 CB 146; Rev Proc 92-12, 1992-1 CB 662, Sec. 4.04)

The currently deductible amount is based on the ratio of borrowed funds used for improvements to the total amount of the loan. (Rev Rul 87-22, 1987-1 CB 146) The balance of the points is deductible over the term of the new loan.

The Eighth Circuit has ruled that a taxpayer who financed the purchase of a residence with a 3-year mortgage loan, and then refinanced in the third year, could currently deduct the points on the refinance loan. (Huntsman, James, (1990, CA8), 905 F2d 1182, 66 AFTR 2d 90-502066 AFTR 2d 90-5020 revg & remdg (1988) 91 TC 91791 TC 917) However, IRS won’t follow Huntsman outside of the Eighth Circuit. (AOD 1991-002,2/11/1991) And the Tax Court has said that the Eighth Circuit’s rule does not apply where the original loan was a 30-year loan and the purpose of the refinancing was to obtain a lower interest rate and a fixed rather than variable interest rate. (Kelly, David, (1991), TC Memo 1991-605TC Memo 1991-605)

How to handle points that can’t be claimed currently. If points aren’t currently deductible under Code Sec. 461(g)(2), they generally must be deducted over the life of the loan using OID-type economic accrual principles. However, IRS says it will, as a matter of administrative convenience, allow a borrower to find the amount deductible annually by:

1. Dividing the non-currently-deductible points charge by the number of monthly payments to be made on the loan, then

2. Multiplying the result by the number of mortgage payments made during the tax year.

This expedient is available only if the points are paid in connection with a loan of not more than $250,000 that:

1 Is payable over no more than 30 years;

2 Is secured by a residence; and

3 Carries no more than six points if the loan term exceeds 15 years, or no more than four points for shorter loans. (Rev Proc 87-15, 1987-1 CB 624)

Observation: The economic accrual method “front loads” the deductible amount (higher deductions in the early years, smaller ones in the later years), whereas the easier-to-calculate ratable method produces a level deduction figure through the loan term.

Deducting interest on the new loan. Interest paid on the refinance loan generally will be deductible under the following rules, assuming it is properly secured and all of the other Code Sec. 163(h)(3) conditions are met:

1. The new loan proceeds are treated as qualified acquisition debt to the extent the new loan amount doesn’t exceed the balance remaining on the original mortgage. Interest paid on qualified acquisition debt of up to $1 million is fully deductible. (Code Sec. 163(h)(3)(B))

2. Borrowed funds in excess of the amount necessary to retire the old mortgage also are treated as acquisition debt to the extent used for “substantially improving” the residence. (Code Sec. 163(h)(3)(B)(i)(I)) IRS says that any improvement that adds to the home’s value, prolongs its useful life, or adapts the home to new uses qualifies as “substantial”. Repairs that maintain a home in good condition, such as repainting the home, are not substantial improvements. But if the taxpayer paints the home as part of a renovation that substantially improves the qualified home, he can include the painting costs in the cost of the improvements. (IRS Publication 936, 2016, pg. 10)

3. To the extent they aren’t used for substantial improvements, borrowed funds in excess of the amount necessary to retire the old mortgage may be treated as home-equity debt. Generally, the interest paid on up to $100,000 of home equity debt is deductible regardless of how the proceeds are used. (Code Sec. 163(h)(3)(C))

Caution:  Even if all of the home-equity debt provisions are met, the interest won’t be deductible to the extent the deduction is disallowed by another provision such as the Code Sec. 265(a)(2) prohibition against deducting interest on debt to buy or carry tax-exempt bonds. (Reg. § 1.163-8T(m)(1)(ii))

Special rules apply for certain refinanced grandfathered debt (generally, debt incurred before Oct. 13, ’87).

Part principal residence, part business property. A person’s home may be used partly for business purposes (e.g., office at home, professional’s office, or rented to others). In these cases, allocations are required, and part of the loan automatically will be disqualified from the favorable qualified residence interest rules. That’s because residence interest is deductible only to the extent the loan is secured by the taxpayer’s principal residence (his or her main home) or another property treated as a residence under the Code Sec. 280A(d)(1) vacation home rule. Thus, to the extent the loan is secured by a home office or rented rooms, it can’t be qualified debt. (Code Sec. 163(h)(4)(A); Reg. § 1.163-10T(p)(4)) No allocation is required, however, if the tenants are residential, there aren’t more than two different tenants, and the rented portion isn’t a self-contained living unit with separate sleeping space and toilet and cooking facilities.

© 2017 Douglas Rutherford, CPA, CGMA, CPLA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

There were a number of important tax developments in the first quarter of 2017.

The following is a summary of important tax developments that have occurred in the past three months that may affect you, your family, your investments, and your livelihood.

New guidance on how small businesses can use research credit to offset payroll tax.

Businesses that increase certain research expenses may use a research credit to reduce their income tax liability. For tax years that begin after Dec. 31, 2015, eligible small businesses can take advantage of a new option enabling them to apply part or all of their research credit against their payroll tax liability, instead of their income tax liability. The option to elect the new payroll tax credit may be especially helpful for eligible startup businesses that have little or no income tax liability. To qualify for the new option for 2016, a business must have gross receipts of less than $5 million and may not have had gross receipts before 2012. Under the new rules, an eligible small business with qualifying research expenses can choose to apply up to $250,000 of its research credit against its payroll tax liability.

The IRS recently issued new guidance on this option for eligible small businesses to use the research credit to reduce payroll tax. Eligible small businesses choose this option by filling out Form 6765, Credit for Increasing Research Activities, and attaching it to a timely-filed business income tax return. The business claims the payroll tax credit on its employment tax return for the first quarter that begins after it files the return reflecting the election. For example, if a business files an income tax return on Apr. 10, 2017, with a Form 6765 attached reflecting the payroll tax credit election, it would claim the payroll tax credit on its Form 941, Employer’s Quarterly Federal Tax Return, for the third quarter of 2017. An eligible small business that files annual employment tax returns claims the payroll tax credit on its annual employment tax return that includes the first quarter beginning after the date on which the business files the return reflecting the election. The eligible small business also must file Form 8947, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and attach it to the employment tax return. Under a special rule for tax year 2016, a small business that failed to choose the payroll tax option, but still wishes to do so, can still make the election by filing an amended return by Dec. 31, 2017.

Fast track settlement program made permanent for small businesses and self-employeds.

The IRS announced that it has made permanent a program that allows small business/self-employed taxpayers and the IRS to reach agreement on tax disputes more quickly. It’s called the Fast Track Settlement (FTS) program, and it’s designed to help certain small businesses and self-employed individuals who are under examination by the Small Business/Self Employed (SB/SE) Division of the IRS. The FTS uses alternative dispute resolution techniques to help taxpayers save time and avoid a formal administrative appeal or lengthy litigation. As a result, audit issues can usually be resolved within 60 days, rather than months or years. Plus, taxpayers choosing this option lose none of their rights because they still have the right to appeal even if the FTS process is unsuccessful.

2017 luxury auto depreciation dollar limits and lease income add-backs released.

Annual depreciation and expensing deductions for so-called luxury autos are limited to specific dollar amounts. These amounts are inflation-adjusted each year. The IRS has announced that for autos (not trucks or vans) first placed in service during 2017, the dollar limit for the first year an auto is in service is $3,160 ($11,160 if the bonus first-year depreciation allowance applies); for the second tax year, $5,100; for the third tax year, $3,050; and for each succeeding year, $1,875. These dollar limits are the same as those that applied for autos first placed in service in 2016.

For light trucks or vans (passenger autos built on a truck chassis, including minivan and sport-utility vehicles (SUVs) built on a truck chassis) first placed in service during 2017, the dollar limit for the first year the vehicle is in service is $3,560 ($11,560 if the bonus first-year depreciation allowance applies); for the second tax year, $5,700; for the third tax year, $3,450; and for each succeeding year, $2,075. For a light truck or van placed in service in 2017, the dollar figures are the same as for such vehicles first placed in service in 2016, except that the third-year amount is $100 higher.

A taxpayer that leases a business auto may deduct the part of the lease payment representing its business/investment use. If business/investment use is 100%, the full lease cost is deductible. So that auto lessees can’t avoid the effect of the luxury auto limits, however, taxpayers must include a certain amount in income during each year of the lease to partially offset the lease deduction. The amount varies with the initial fair market value of the leased auto and the year of the lease, and is adjusted for inflation each year. The IRS has released a new inclusion amount table for autos first leased during 2017.

IRS delays employer deadline to provide small employer HRA notice to employees.

Generally effective for years beginning after Dec. 31, 2016, an eligible employer—generally, an employer with fewer than 50 full-time employees, including full-time equivalent employees, that does not offer a group health plan to any of its employees—may provide a qualified small employer health reimbursement arragement (HRA) to its eligible employees, and such an HRA won’t be treated as a group health plan. Thus, a qualified small employer HRA isn’t subject to the tax law’s group health plan requirements, including the portability, access, and renewability requirements of the Affordable Care Act (ACA, also known as Obamacare). HRAs are arrangements under which an employer agrees to reimburse medical expenses including health insurance premiums up to a certain amount per year, with unused amounts available to reimburse medical expenses in future years. The reimbursement is excludable from the employee’s income.

The qualified small employer HRA rules generally require an eligible employer to furnish a written notice to its eligible employees at least 90 days before the beginning of a year for which the HRA is provided (or, in the case of an employee who is not eligible to participate in the arrangement as of the beginning of such year, the date on which the employee is first so eligible). However, under interim guidance from the IRS, an eligible employer that provides a qualified small employer HRA to its eligible employees for a year beginning in 2017 isn’t required to furnish the initial written notice to those employees until after further guidance has been issued by the IRS. That further guidance will specify a deadline for providing the initial written notice that is no earlier than 90 days following the issuance of that guidance.

© 2017 Douglas Rutherford, CPA, CGMA, CPLA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

The IRS has announced an increase in the de minimis safe harbor limit to $2,500.

As you may know, the IRS recently issued new complicated capitalization rules. With those new rules came a safe harbor election that allows taxpayers to deduct up to $500 per invoice line item. As an example, if you were to buy 10 window air conditioners at $495 each for your apartment complex, you could elect to deduct the entire $4,950 as a rental expense. (1.263(a)-1(f))

Great News!

The IRS has announced an increase in the de minimis safe harbor limit to $2,500.  This new rule change could have a tremendous impact on rental cash flow because it may reduce the amount of income taxes owed.

The de minimis safe harbor was intended as an administrative convenience to permit a taxpayer to deduct small dollar expenditures for the acquisition or production of new property, or for the improvement of existing property, which otherwise must be capitalized under Code Sec. 263(a). It does not limit a taxpayer’s ability to deduct otherwise deductible repair or maintenance costs that exceed the amount subject to the safe harbor—a taxpayer may continue to deduct all otherwise deductible repair or maintenance costs, regardless of amounts—but merely establishes a minimum threshold below which all qualifying amounts are considered deductible.

A recap of the safe harbor election requirements:

The de minimis safe harbor applies to an amount paid during the tax year to acquire or produce a unit of property (UOP), or acquire a material or supply, only if:

1. The taxpayer has, at the beginning of the tax year, written accounting procedures treating as an expense for non-tax purposes amounts paid for property (1) costing less than a specified dollar amount; or (2) with an economic useful life of 12 months or less;
2. The taxpayer treats the amount paid for the property as an expense on its books; and
3. The amount paid for the property does not exceed $2,500 per invoice (or per item as substantiated by the invoice).

Effective date/audit protection

This increase is effective for costs incurred during tax years beginning on or after Jan. 1, 2016, but use of the new threshold won’t be challenged in tax years prior to 2016. And, if a taxpayer’s use of the de minimis safe harbor is an issue under consideration in examination, appeals, or before the U.S. Tax Court in a tax year beginning after Dec. 31, 2011 and ending before Jan. 1, 2016, and the issue relates to the qualification under the safe harbor of an amount that doesn’t exceed $2,500 per invoice (or item, as substantiated by invoice) and the taxpayer otherwise satisfies the applicable requirements, IRS won’t pursue the issue further.

 

Note: De minimus safe harbor election pursuant to 1.263(a)-1(f).

Contact us for a sample election that you must attached to your tax return.

© 2015 Douglas Rutherford, CPA, CGMA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

Real Estate Tax Deprecation Recapture

Wow!  The recently passed tax law just lowered the capital gain tax rate… great, uh?  Well yes, but not so fast!  We all know how important it is to understand how the tax law affects our real estate investments.  Understanding and forecasting the tax ramifications of rental property ownership is a critical step in the screening and decision making process.  Misunderstanding and misapplying the tax law during your analysis can result in ghastly surprises.

As a real estate investor, you can depreciate our rental property and enjoy the positive cash flow resulting from write-off of tax depreciation.  Tax depreciation helps shelter rental income that is subject to “ordinary income” rates which is generally higher than capital gain rates.  The depreciation taken reduces our property’s tax basis which effectively increases our tax gain when we later sell.  If the property is later sold at a gain, this gain may have resulted from the depreciation we took.  To the extent the gain is attributable to depreciation taken, this gain is generally referred to as “recapture”, or Internal Revenue Code (IRC) Section 1250 gain.

The Taxpayer Relief Act of 1997 imposed a 25% capital gains tax rate for unrecaptured IRC Section 1250 gains. When coupled with the changes made by the 2003 Tax Act, all depreciation taken can give rise to a higher rate of tax than the newly reduced 15% long-term gain rate.  The effect of which is that you will most likely pay more tax upon the sale of a rental property than the 15%.

By way of example, let’s assume you purchase a rental property today for $100,000.  The total tax depreciation you plan to take over your estimated ownership period is $25,000.   You also project the property will be worth $140,000 when it is time to exit your investment.  Your projected tax gain will be $65,000 ($140,000 less $75,000 ($100,000 cost less $25,000 depreciation)).  Since your gain is greater than your accumulated tax depreciation, the recapture rule will apply.  As a result, your tax on sale is not $9,750 ($65,000 x 15%), but rather $12,250, 25.6% more in taxes than what you planned!

The amount subject to the higher (25% or ordinary) rates is limited to the gain on the Sec. 1250 property. If the gain is allocable primarily to the land, the rate of tax on the overall gain from sale may be brought back toward the lower 15% long-term rate. The consequences could range from no benefit for buildings which have increased in value above their original acquisition basis, to significant benefit where a building is close to the point of being demolished, the principal value component being the land.

As an example, if accumulated depreciation (otherwise subject to “unrecaptured section 1250 gain” treatment) is $10,000, but analysis can reduce the gain attributable to the building at the date of sale to $6,000, then the federal income tax to a high bracket taxpayer on the $4,000 reduction is reduced from $2,500 to $1,000. The result is a $1,500 tax savings for simply be able to allocate more of the gain to land that is not subject to the recapture rather than the building.

In summary, make sure you take into consideration the potential depreciation recapture tax bite when performing your cash flow and rate-of-return analysis.   When you have tax questions, always consult your tax advisor.

© 2015 Douglas Rutherford, CPA, CGMA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.