Own where you live -- you've probably heard that expression thousands of times. But what makes home ownership so great?
First off, owning your home saves you taxes. Unlike rent which isn't tax deductible, paying a mortgage and real estate taxes is deductible on your federal tax return. Let's say you have a $200,000 mortgage with an interest rate of 6%, and you pay $3,000 in real estate taxes each year. If you're in the 30% tax bracket, you'll save $4,500 in federal taxes this year. That's a tax savings of $375 per month.
Home ownership also provides you with a tax-free way to accumulate wealth. Under the current tax rules, when you sell your principal residence, you won't be taxed on the first $250,000 of appreciation if you're single, or the first $500,000 of appreciation if you're married, as long as certain conditions are met. So what does that mean to you? Unless you sell your home for more than $500,000 ($250,000 if you're not married) above what you paid for the home plus improvements, you won't pay a dime in taxes. And don't forget that the rules changed back in 1997. You no longer need to roll over the proceeds from the sale of your principal residence into a more expensive home within two years to avoid paying taxes on the gain realized.
When you own a home, you also have a nice hedge against inflation. Think back to your days as a renter. How many years can you remember that your landlord didn't increase your rent? When you own a home, if you have a fixed rate mortgage, your monthly payment remains fixed over the life of the loan. As inflation causes the price of everything else to increase, it's nice to know that your largest monthly bill will remain constant.
There are times when owning a home might not make sense. If you're not sure where you'll be living two or three years down the road, you might be better off remaining a renter for the time being. That's because the transaction costs of buying and selling a home can be as high as 10% of the cost of the home. Unless your home appreciates by 10%, you could end up losing money when you sell it to move to a new city.
Is now a good time to buy your first home or to upgrade to a more expensive home? Interest rates are extremely low, but home prices are generally quite high throughout the U.S. In the short-term, therefore, you might overpay for a home if there is a correction in the housing market. In the long-term, however, owning a home (that doesn't break the family budget) is a key ingredient to most people's financial well being.
The stock market has done nothing but gone down over the past three years. And savings accounts and money market funds are currently only yielding about 1% these days. Both of these factors have contributed to a boom in the real estate sector that has sent prices soaring throughout the U.S.
If you're fortunate enough to own real estate, you're probably sitting on a substantial amount of appreciation. What happens when you sell your real estate? How much will you end up paying in taxes on the gains you realize?
If you're selling your principal residence, the rules are quite liberal. You won't pay any taxes on the first $250,000 of gain if you're single or $500,000 of gain if you're married, as long as certain conditions are met.
When selling rental or business property, however, you're not so lucky. In fact, the taxes you owe could be substantial. Not only will you be taxed on the property’s appreciation, you'll also be taxed on the depreciation you claimed over the years. Let's say that you purchased a building for $390,000 that you owned for 10 years, and can now sell for $780,000. Assuming you claimed depreciation of $100,000 over the years, you'll owe taxes on a gain of $490,000 ($780,000 - $390,000) + $100,000).
Fortunately, by structuring the sale of your real estate as a “deferred exchange”, you can avoid paying taxes on the gains your realize. Also known as a "like-kind exchange" or a "1031 exchange", this tax saving opportunity is available only in connection with the sale of investment and business assets. Vacations homes and other personal-use property don’t qualify.
With a deferred exchange, you'll only pay taxes on the portion of the sales proceeds that either isn't reinvested into a new property or is used to decrease your outstanding mortgage debt. By choosing replacement property that is more expensive than the property you’re selling, you'll generally avoid paying any taxes whatsoever.
The rules for a deferred exchange are quite specific and must be followed very closely for this tax savings strategy to be successful. Here are the basics:
While deferred exchanges can be quite complex transactions, taking advantage of this tax savings opportunity could save you thousands of dollars of taxes. If you plan on selling real estate that you own, make sure to learn more about deferred exchanges before placing that property on the market.
February, 2001 Newsletter or read through the IRS' Chief Counsel Advice Memorandum on this issue.
copyright - 2003 - The MDTAXES Network
Tax and financial planning calendar for May, 2003
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