One of the great benefits of buying a house is the tax advantages the United States government gives to property owners. Tax laws allow homeowners to pay no taxes on the sale of a home if they have lived in it as their personal residence for at least 2 out of the last 5 years, and owned the home for at least 2 years (some restrictions apply and always talk to an accountant for specific tax questions). If you invest in real estate there are some awesome tax advantages as well like being able to depreciate properties. Home owners can also deduct the interest portion of their mortgage payment from their taxes. Here is the exact law from the IRS website.
For more information on my investing strategy please check out my complete guide to purchasing long-term rental properties.
How can you pay no taxes selling a house?
Because you are able to pay no taxes on the profit of a home when you live in it as your personal residence, buying a home below market value can be a huge advantage. You may have to buy a home that needs work, but you can repair the home before moving in, or repair the home slowly over the next two years. Once you have lived in the home for two years, sell the home, and hopefully make a large profit. You will pay no income taxes on that money you make as long as you do not make over $250,000, rent the home out, or use the home for business. Once the home is sold, you can repeat this process over and over.
You can use the profit from the home you sold as a down payment for your next house, which may allow you to keep buying more expensive homes. You could also buy the next home with as little down as possible, and use the cash you made to invest in rental properties or something else. The best part of this strategy the taxes are not deferred like they would be with most retirement plans or a 1031 exchange, they are forgiven forever.
Choosing a house to buy and sell tax free
The most difficult part of the strategy is finding the right home to buy, especially for those of us with families. As many of us know, our families don’t always want to move into a house that needs a lot of repairs or maintenance. We also may not have a flexible enough schedule to be able to wait for a great deal. I knew about this strategy when I bought my first house and completely ignored it for a few reasons:
- The market was very strong for sellers, there were not many fixer uppers available and I did not know how to find the great deals like I do now.
- I was also very young and not as concerned about my future as I should have been.
In many markets we are seeing very strong sellers’ markets with multiple offers and low inventory. However, there are still many opportunities for owner occupied buyers to find good deals. Many banks and HUD offer their foreclosed homes to owner occupied buyers before they offer them to investors. This gives owner occupied buyers a huge advantage, especially with HUD when looking for a home. Here is a link to my owner occupants guide to purchasing HUD homes. This guide details how to find HUD homes, how to bid and strategies for winning the bid. Fannie Mae, Freddie Mac and Wells Fargo also offer owner occupied programs on their REO properties. If you are buying a home for your personal residence you can usually get a mortgage with a 3.5 percent down payment or less, depending on what loan programs are available in your area.
My article on how to find a great deal for a rental property also applies to finding a personal residence. This is article tells you the best places to find a good deal on a home that will give you a nice profit in two years. My first house was not a great investment and I ended up selling it for less than I bought it for after owning it for 7 years and putting a lot of money into updates and repairs. However, the second house I bought as my personal residence has been a great investment. We bought this house at the foreclosure sale and were lucky to find a house we loved, didn’t need a lot of work and was a great deal. We had to borrow money from my sister and father in law to make it work, but it was well worth it. We are actually buying another house for our personal residence soon and selling our current house. We already have a buyer for our current house and will walk away with over $100,000 profit, after owning it for about 4 years. It is all tax-free money because we have lived here all four years and that money will provide the down payment for our new house.
Selling and buying a new house tax free
Selling a house can be tricky, if you have to sell your current house before you can buy another. If you have to sell your current house to qualify for a loan and purchase a new house, it is called a contingency. Buying a house with a contingency provides a few problems when trying to maximize profits. You have to time the sale of you house and the new purchase perfectly, usually in a two or three day span and sometimes on the same day. Finding a buyer and then finding a great deal that works in that time frame is almost impossible. Another issue with a contingency is most banks will not accept a contingency on their REO properties, and it makes your offer weaker in a competitive market. If a seller has multiple offers on their home, they are going to take the offer that they think will give them the most money, and has the best chance to close. They will choose the offer without a contingency over the offer with the contingency, if the money is similar.
The ideal situation is to buy a new home without selling your current home, and have plenty of time to move and get your current home ready to sell. This is not a reality for many people because they tend to buy the most expensive house they can afford which I advise against. If you are not able to qualify for two homes, the next best choice is to sell your current home and move somewhere temporarily, while you look for another great deal. Once your house sells, you will be able to make offers on HUD homes and REOs which are usually the best deals. If you want to buy a short sale, you almost certainly have to use the double move technique, because there is no set time frame for closing on a short sale until the bank accepts the terms. Many banks will not accept contingencies on short sales either.
Continue the process over and over without paying taxes
This strategy can be used over and over again as many times as you can handle it. It is a great way to gain cash for investing or a down payment on nicer homes every time you buy and sell. It is not easy to do for a variety of reasons and this is why very few people actually utilize this strategy. Many times a spouse or family member does not want to move into a fixer upper, wait for a great deal or have to move every two years. In my case, you may find your dream home that may not be a great deal, but you feel you will not have an opportunity to buy a similar home in the near future or ever again. If you can pull off this strategy a couple of times or even once, the extra money can make a huge difference in your life.
Potential roadblocks for using this tax free strategy
Nothing ever works out exactly as we plan. Sometimes it works out better and other times things don’t go quite as well as we hoped. There are a few things we have no control over that can delay or derail this strategy.
- A significant decrease in values can cause some serious delays and decrease profits significantly. If you bought the house below market value and bought a house you can afford then you should be able to make a small profit if you need to sell or ride out the market until prices improve.
- Selling your home before you have lived there for two years can also decrease the profit potential. If you’re transferred, have a great opportunity you can’t pass up or simply have to get out of the town you are in, you may have to sell early. If you make a profit on the home you may have to pay taxes on that profit, but you are still making money and coming out ahead of where you were before.
- Many people fall in love with their homes and don’t want to move. If this happens to you, there is nothing that says you have to sell your home every two years and buy a new one. If you love your home and it means more to you than the money you would make from selling it, stay and enjoy it. The nice thing about this strategy is you don’t have to follow it to a tee to make it work. You can stay in your home longer and change the plan as you go to suit your family’s needs.
What other tax advantages come from buying a house?
Besides avoiding taxes altogether when living in a house as an owner occupant, you also save money on taxes from your mortgage payment. The government wants people to buy houses. That is why they make the tax laws so advantageous and encourage home buyers with government backed low down payment loans. When people buy houses, the economy does better.
When you have a mortgage on your personal residence, or even an investment property, the interest is tax deductible. When you have a mortgage on a home, part of the payment goes to principal and part of the payment goes to interest. In the beginning of the loan, much more money goes to interest than principal. Here is what the interest and principal would look like on a $190,000, 30 year loan, with a 5 percent interest rate:
- Total payment: $1,020
- Interest portion of the payment: $792
- Principal portion of the payment: $228
This payment does not include any mortgage insurance, taxes, or insurance, which we will talk about more later on. The loan will be paid down $228 the first month, while $792 is interest paid to the bank. In the first year $10,216 will be interest paid to the bank. That seems like a lot of money, but the interest portion of the payment will slowly decrease over time. That $10,216 is tax deductible, which means if you pay taxes in the 28 percent tax bracket, you would save over $2,800 a year. If you are renting a home, you would not be able to deduct any of the rent from your taxes.
What are the tax advantages of rental properties?
Rental properties also have some awesome tax advantages:
- Just about every expense is deductible or can be depreciated since you are running a business.
- The structure can be depreciated, which means you can save thousands of dollars a year on your taxes simply by owning a rental.
- If you own a rental property long enough you can sell it at the lower long-term capital gains tax rate.
- You can defer taxes when you sell rentals, by using a 1031 exchange.
This strategy is very simple, but hard to utilize in the real world. No one likes to move every two years, especially if you have to do a double move and stay somewhere temporarily while you find a new house. It can be difficult to convince our families that moving is worth it, especially if the kids have to change schools. It takes money and hard work to fix up a home, and the good deals are not always our idea of the perfect home to live in. If you can manage to pull this off even once, you can make a huge profit and pay fewer taxes. To many people, the extra money can be life changing and allow them to start investing and get ahead in the game.
If you are looking for a way to save money on your taxes in other areas of real estate, please see a good accountant. They will save you much more money than it will cost to consult with them and you will know you are doing it by the book.