While tax day normally falls on on April 15, the IRS has extended the due date for Californians (and others) who were affected by the severe storms earlier this year to October 16, 2023. See here for more on this. For everyone else, tax day this year is on Tuesday, April 18th, because April 15 falls on a Saturday and Emancipation Day will be observed on Monday, April 17th.
With a little over a month left until the regular deadline, gathering and organizing income and expense documentation related to businesses and other income-producing activities in 2022 is a top concern for many people these days. If it’s not on your radar, perhaps (1) you are too busy to think about it, or (2) taxes are complicated and overwhelming so you’d rather push it off until the very last minute. No judgment here, this is me almost every year.
Your main objective might be to simply to file and pay your taxes on time, with as little work and time put into it as possible. If so, you likely base your tax calculation on whatever tax documents you received to report the income that you earned in 2022, say, from your employer or brokerage accounts. What you should know, however, is that the less attention you devote to your taxes, the more likely you will end up overpaying Uncle Sam. This is because sufficient planning and understanding of tax laws is often required in order to benefit from any tax-savings strategy.
You see, the tax definition of income (which increases the amount of taxes you owe) is broad and encompasses “income from whatever source derived.” Income is generally taxed unless it is specifically exempted by law, and you can expect the government will come knocking at your door to tax any income you fail to report, sometimes with interest and penalties if late. Note also that there are mechanisms in place for the government to track your income (think of any Forms W-2 or 1099 you received in January).
On the other hand, tax deductions or credits (which decrease the amount of taxes you owe) must be specifically allowed by tax law and proactively claimed by you in order to be factored into your tax calculation. In other words, you cannot rely on the government or anyone else to tell you which deductions or other tax breaks for which you may be eligible that you forgot or were unaware of.
Highlighted below are four common tax advantages of owning real estate that may apply to you. Real estate ownership not only provides opportunities to save a significant amount in taxes, but it is also one of the best wealth-building strategies out there.
TAX ADVANTAGES OF OWNING YOUR HOME
Deduction of home mortgage interest expense: This is often the largest itemized deduction on a taxpayer’s individual tax return, which translates into the greatest decrease in the amount of taxes owed. Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home or a second mortgage.
For 2022, you can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of debt. If you are deducting mortgage interest from a loan you took out before December 16, 2017, higher limitations apply: $1 million ($500,000 if married filing separately).
Note that interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan. The loan must be secured by the taxpayer’s main home or second home (qualified residence) and meet other requirements as well.
Tax exclusion for sale of primary residence: If you sold your main home for a capital gain in 2022, you may qualify to exclude up to $250,000 of that gain from your income ($500,000 if married filing jointly). This rule will allow you to retain a significant amount of your capital gains, and you can use those tax-free gains to purchase a new and upgraded home.
Generally, you must meet two tests to qualify for the exclusion:
Ownership - you must have owned the home for two years during the last five years prior to claiming the exclusion, and
Residence - you must have used the home as your principal place of residence (your main home) during two years of the last five years. This time need not be consecutive or the most recent.
Among other exceptions, your home sale does not qualify for capital gains tax exclusion if it was purchased as part of a 1031 exchange (see below), or if you claimed the exclusion previously during the two-year period before the date of sale.
TAX ADVANTAGES OF OWNING INVESTMENT PROPERTY
Depreciation: Tax laws allow the owner of investment real property to take an annual tax deduction (this is without actually spending money) for the structure's depreciation, e.g. wear and tear, deterioration, or obsolescence of the property. This reduces taxable income by the depreciation allowance, even though in reality the asset may appreciate in value.
Tax deferral for sale of like-kind investment property (AKA “1031 exchange”): If you sell or plan to sell your business or investment property, you may be able to postpone all or some of the capital gains tax on the sale by using the proceeds to buy a similar “like-kind” (this does not mean exactly the same, and there is some flexibility here) property. If done correctly, the 1031 exchange is a powerful wealth-building strategy. In essence, you can use tax-deferred gains from the sale of one investment property to reinvest into a larger or more profitable investment property. Timing and tracking funds are key to a valid 1031 exchange, so careful planning is required to avoid immediate disqualification and taxation.
General requirements are:
You should not receive any proceeds of the sale (a neutral “qualified intermediary” holds the funds in escrow),
You have 45 days from the date of sale to identify potential replacement properties, and
You must close on the new property no later than 180 days after you sell your old property or after your tax return is due (whichever is earlier).
The bottom line is that taxes are inevitable, but you have options to reduce or defer how much you pay so you can instead preserve and build wealth with tax dollars saved. Real estate ownership is one way to do this.
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Jina Lee and/or METIS Real Estate do not provide tax, legal or accounting advice. This article was written for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.