Home, Sweet Home…Tax Break!
Let’s talk for a bit about taking your personal residence and converting it into a rental.
“Hold on a minute,” you say. “What’s there to talk about?”
On the surface, it’s simple, right? You might be ready to move up in the world, so to speak, but you don’t really want to sell your house. You know it’s got a great location, it’s probably going to continue to appreciate in value, and you suspect that it could bring in a handsome rental income for you.
So why not just move out, spruce the place up a little, and put out the advertisement?
Nothing Wrong With That…On One Level.
It’s easy, it’s straightforward, and you’ll get a certain benefit out of it. But if you want to profit even more from this exercise, there’s a better way. In this post, I’ll show you how to take your personal residence and SELL IT to your business…and THEN rent it. It’s a difference you’ll feel at tax time!
Here’s How It Works.
Let’s say I bought my house 15 years ago for a purchase price of $200,000. Fast-forward to today, and that same residence is worth $500,000.
Now, if I take that personal residence and turn it into a rental, then I can start depreciating my tax basis. That tax basis is $200,000, or the original purchase price. That ends up being worth about $8,000 a year, which becomes how much I can write off from my rental income.
So, if I bring in $20,000 per year in income and write off $7,000 of that in depreciation, that will leave me with $13,000 of taxable income. But, quite frankly? I don’t l like those numbers. I want more than that $7,000 break. In fact, I’d love to double that amount.
What enables me to do that?
The Magic of the S Corporation!
The first step is to HAVE a separate entity that can buy your home from you — an S corporation. You create it, and then you sell your house to it. Now, of course, you’re IN this corporation; it’s your business, and it’s going to buy your house via an installment sale.
Never heard of this method? You’re not alone. But it’s a simple process that can net you great results.
When you execute an installment sale, you bring in money over a given period of time. It’s the same principle as buying anything (a car, a luxury home, a vacation) by making “payments” on it…or the way you pay off credit in general. The same thing applies to this sale you’re doing with your S corporation. We also want to qualify this for Section 121 as well — which is the provision by which you can sell your property and exclude up to $250,000 of the capital gain if you’re a single taxpayer, and up to $500,000 if you’re a married couple.
So under this scenario, the next thing I do is to sell my house to the S corporation on a 20-year installment sale. I’m not going to receive all the funds up front; I’m going to get them over 20 years. And I’m going to lock in that Section 121 protection because — remember — the corporation is not YOU. It’s a separate taxpaying entity. Much the same way as selling a home to any private buyer would kick in the Section 121 benefits, selling your house to your S corporation, a separate party, does the trick.
When the sale takes place, the corporation’s tax basis becomes what it pays for the house, or $500,000. The corporation takes the property over, and I’m no longer on the same tax basis as I would be with a straight rental arrangement; my tax basis now is $500,000, in the hands of the S corporation. If the CORPORATION brings in $20,000 in rent, it can depreciate $17,000 of that; this means that instead of $12,000 in income being my personal tax responsibility, only $3,000 is.
Voila! We’ve cut your taxable income by $9,000, just by your selling the house to an S corporation rather than going straight to rental. How great is that?
But Amazingly Enough…It Gets Better.
Remember, you’ve sold the property to your corporation. We’re going to qualify it under Section 121 so we can exclude up to $500,000 in gain, and we’ve got $300,000 of that. When I sell it, in the year of the sale I’m going to opt-out of installment sale treatment. That is, I’m going to tell the IRS, “Yes, I sold this property on an installment basis, but I’m going to treat all that gain as happening in the year of the sale.”
That will result in a $300,000 gain — but since it’s under Section 121, you can exclude up to $500,000, which means you net no tax liability personally. Going forward, the same thing holds, even though this corporation makes payments under the installment sale. So if, for example, it pays you $15,000 a year, none of that is taxable income for you: it’s all part of the sale.
Let’s say that again.
Up to $500,000 will be paid back to you out of your corporation, none of which is taxable to you personally because you qualified this as a sale of a personal residence under Section 121. Nothing. Zero. Nada.
Sounds Complicated…But It’s Not.
While this process is detailed, it’s actually fairly simple to do. And the savings you can reap over going the direct-rental route are substantial. If those savings are calling to you, call US at Anderson Business Advisors, and we’ll be happy to help you set it up for your property.
Want more ideas on saving your investment dollars? Then check out our “Millionaire Tax Strategies”
workshop — where we talk about this process and 57 others you can use to reduce your taxes if you’re a real estate investor or small business owner. Give us a call today and let the saving begin!