Another strategy to consider when you purchase or
sell a home is how you can take advantage of the
deductibility of home mortgage interest. This is one
case where debt can be useful. But, briefly, the trick
is to mortgage your property (especially at low
interest rates) and then put the money into tax-free
investments. Thus, if you mortgage the property at
6%...and put the money into tax-free investments
yielding 6%...it looks like a wash. But you actually
end up ahead. Say the amount is $100. Your mortgage
costs you $6, which you deduct from your taxes. At a
40% tax rate, the real cost of the $6 payment is only
$3.60. That is, it reduces your taxable income by
$6...thereby sparing you $2.40 in taxes. Plus, you get
another $6 in tax-free interest. Using this technique,
you'll end up with $8.40 in tax-free earnings...or 8.4%
tax free, instead of only 6%. In other words, you
increased your tax-free earnings by 40% with no
increase in risk.
If you sell a home for a $100,000 gain, and buy
another one at the same price, using this trick you'll
put $200 in your pocket, tax free, each month!
While your home can, in a sense, be free to you
because of its long-term wealth-generating potential,
it can also be free for all the years you live in it --
as you continue to build wealth. The key is to make
your home a deductible expense.
If moving away is just not possible for you right
now, set up a business within your home. You can deduct
some of your home expenses through the business.
If you buy a personal residence for $300,000 and
are taxed at a 40% rate -- which many, if not most,
people are -- you would have to earn at least $500,000
to pay for it. And that doesn't include a penny of
interest on the mortgage (which is deductible). No
matter how much you pay, your investment is worth
whatever the property is worth -- which, as we have
seen, might be a lot less than you anticipated.
But suppose you could make the purchase a
deductible expense? In some special situations, you
can. If a business purchases a property for $300,000,
and depreciates the expense over the mortgage period,
the cost to the company would be only $300,000 rather
than $500,000 -- a $200,000 savings. Remember, though,
land is not depreciable -- to anyone.
Similarly, investment property may be depreciated
(deducted over a period of years). Here again, the real
cost of acquisition is greatly reduced.
The trick then is to turn residential property
into business or investment property, thus allowing you
to deduct the cost of acquisition and thereby save
enough money to give you a new home free.
You cannot depreciate your primary residence. By
definition, the place you live is a personal expense,
not a business or investment expense. But if you buy
another home, for investment purposes, you would be
able to deduct the expenses, including the
depreciation. Likewise, if you have a business of your
own (this is just one of the many instances in which
having a business can pay off), and the business needs
a place to operate from, you can -- in certain cases --
have the business buy a property and deduct the
expenses. In this case, the business would buy a place
from which to conduct business. And you would rent from
the business a portion of the property as a living
space.
This is the opposite of the typical "office in the
home" situation...from a tax perspective. At the same
time, it is precisely the same arrangement. But in
this case, the property is business property, and as
such, fully deductible. You just have to pay fair
market rent for the part of the place you occupy. The
value of the portion you occupy will be significantly
depressed by the fact that you share the residence with
a business. You can imagine how much less it would be
worth to you if you had to share with such a business
and adjust the rent accordingly.
The rent is not, of course, a business expense.
It is a personal living expense and cannot be deducted.
Still, the savings may be significant.
Your incorporated business buys a house (watch out
for zoning and other regulatory problems) from which to
conduct business. It pays $200,000 and deducts both
the interest and the principal (as depreciation) over
the life of the mortgage. Thus the total cost of
acquisition is $200,000...before tax dollars. The
house would rent for $1,500 a month. But since you
have to share the property with a business...a fair
market rent may be just $750, maybe even including
utilities. Meanwhile, the business gets to deduct the
maintenance, utilities, and other costs of operation.
The only taxable amounts involved are the monthly
payments you make to the business in rent. And you
have to watch out that you don't end up getting these
amounts taxed twice, or even three times...by ending up
with a profit in the company, which is taxed at the
corporate rate, and then paying it out to you again ...
where it is taxed at your personal rate. You have to
pay attention, in other words, to the details in a
transaction like this.
How much can this arrangement save you? Let's say
the mortgage payments are $2,000 per month for 20
years. You can only depreciate the improvements, not
the lot, of course, but let's not make this example too
complicated by assuming that the lot has minimal value.
So you get to deduct the entire $200,000 purchase price
over the 20-year period. (Be sure to check allowable
depreciation schedules.) Plus, let's say upkeep and
utilities average $200 per month...all deductible as
well, for a deduction of another $48,000. This brings
a total deductible amount of $248,000... which is a
savings of $99,200 in taxes.
But, remember that we still have to pay the tax on
the rent we pay. Alas, that amount works out to
$72,000. So the net effect is a savings of a little
more than $27,000.
However, the savings do not occur all at once.
They're spread out over 20 years. Thus, the magic of
compounding comes into play. Each year, you save about
$1,350. With compounding at 10%...at the end of 20
years, you'd have $55,806. Here's another variation:
Your corporation can lease your land from you and
build a house on it. You rent the house until it
reverts to you at the expiration of the lease. The
house can be in Hawaii...or the Upper East Side of New
York City. The corporation depreciates the cost of
construction and deducts the cost of maintaining the
house.
The corporation's lease payments to you for the
use of the land are deductible to the corporation.
Your rental payments for the use of the house are
income to the corporation.
When the land lease ends, say after 20 years, the
land and building are both yours. You need not
recognize any income as a result of the improvements
the corporation made to your land. Your basis in the
house will be zero, because you recognized no income.
If you sell the house, all proceeds will be long
term capital gains. If you occupy the house as your
residence and are qualified (over age 55, file a joint
return with your spouse, and have lived in the house
for three out of five years), you can take advantage of
the one-time $125,000 exclusion. On the other hand, if
you leave the property to your heirs, the value to them
will be the fair market value at the time of your
death, and the capital gains will never be taxed.
Now, having said all that, we hasten to add that
any time you start to fool around with IRS regulations
you run into problems. Basically, the IRS has the job
of collecting money from people. And though it is well
established that you have the right to organize your
affairs in any way you please in an attempt to lower
your tax liability, the IRS and Congress are determined
to try to prevent you from exercising that right.
We'll have a lot more to say about taxes in this
book. Because they are by far the biggest single item
in most family budgets. As such, they are also the
most fertile field for growing your personal wealth by
reducing the amount of taxes you pay.
But for now, let us just point out that you need
expert advice to set up a tax-avoiding structure such
as the one we are explaining here. The specific form
of the structure will depend on your own personal
situation and your goals.
