Hey folks, remember when we last chatted about real estate a few episodes ago? I know, I know, taxes weren’t on the agenda then, but let’s delve into it now. Trust me, even some seasoned advisors seem to overlook this crucial aspect. So, sit tight and let's unravel this tax maze.
First off, let's dust off our tax code understanding. You might ask, "What makes my house qualify for capital gains exclusions, Leibel?" Well, you need to have lived in it as your primary residence for at least two of the past five years. Let me walk you through how it works.
Understanding Capital Gains
Suppose you bought a charming little place for $100,000 and eventually sold it for a neat $200,000. Your capital gain? That's the difference between your buying and selling prices, making it $100,000 in this case. Now, many folks would think they'd have to pay tax on that full $100,000, but that's where the tax code becomes your friend. It provides a sort of safe harbor, an exclusion that allows you to not count a certain sum as taxable income if you sell your primary residence (given that you meet the living criteria, of course).
If you're a lone ranger, this exclusion limit is $250,000. If you're hitched, it's even better - you can exclude up to $500,000. So, all that capital gain from selling your home up to these limits? They're safe from Uncle Sam.
Now, here's where the forward-thinking you comes into play. Keep an eye on how much your home has appreciated, and what taxes you might be liable for when you sell it. Sure, that $500,000 exclusion sounds like a truckload of money now, but 20 or 30 years down the road, it might be a different story.
Track Your Cost Basis!
The other player in this game is your property's cost basis, typically what you initially paid for your home. But, my friends, you can be smart and adjust this cost basis with capital improvements made to the property. Major renovations, new additions, floor replacements, boiler installations, and other considerable improvements can increase your cost basis. And higher cost basis equals lower recognized profit and hence, lesser tax. So, be diligent about tracking and documenting these improvements over your ownership period.
Selling an Investment Property
Investment properties, now, these beasts are a completely different game, aren't they?
Investment properties, unlike personal homes, are businesses, and just like any business, they have income, expenses, and yes, that pesky thing called depreciation. Assuming your tax preparer has been on the ball, they started depreciating your investment property from year one.
Let's use our favorite $100,000 property for this example. You can depreciate that value over approximately 27 years. During this period, the depreciation counts as a loss, an 'deduction' in tax parlance, even though no real money exits your pocket. This faux-expense can offset your revenue, reducing your taxable income.
Racking Up Paper Losses
This is another way the tax code encourages us to become landlords and real estate investors. The tax code, ladies and gentlemen, isn't some grueling document designed to make our lives harder - it's a playbook. It nudges us towards certain behaviors, like buying investment properties for that sweet, sweet depreciation benefit.
Now, let's dive a little deeper into the practicalities. Imagine your investment property rakes in $1,000 a month in rent, but you spend $500 on its maintenance. With depreciation in the picture, you might, on paper, end up showing a loss, even if you're earning real income.
Don't Let Depreciation Bite You On The Way Out...
But here's the catch. When you sell your investment property, the IRS will want you to recapture that depreciation. Every dollar of depreciation you claimed will need to be added back into your income, and guess what, it's taxable. And don't forget about those capital gains. Using our $100,000 property example, if you sell it for $200,000, you've got another $100,000 in capital gains to deal