Your home can, in a sense, be free to you for all the years you live in it. The key is to make your home a deductible expense.
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 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 (especially if it is a corporation) 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.
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.
Now: let's add in the deductibility angle.
Many of the regions of opportunity are rural, farming areas. And there's a special angle in the tax law that could turn this into an important and powerful wealth-building tool.
Instead of buying a house, you buy a "farm." There's nothing that says a farm has to be big. It might only be a couple of acres. But to make this work, it has to be serious.
You lease the farm to your corporation. Your company will do the farming, just as the big agri-businesses do. Then your company figures it needs you on the scene to help do the farm work. So it makes you a deal. It builds you a new house...and you agree to live in it and attend to the farm chores. Guess what? Now the house is depreciable by the company -- meaning that the company can deduct it over time. The costs of maintaining the house are deductible currently. Even utility costs may be deductible.
And guess what else. You don't have to pay the corporation rent. That's the deal with the company. You didn't really want to live in the house. You're just doing it as a convenience to the company. That's why it's a deductible company expense...and not income to you.
And guess what else. After the lease expires on your land, what happens to the house? Does the company pick it up and move it off? No way. It wouldn't make economic sense. It leaves it where it was. You get it FREE. Wait until you see what this does to your bottom line!
You sold your $200,000 house. You bought the (farm) land for $20,000, let's say. You paid off the mortgage. You might have lent the other $80,000 to the corporation to build the house, but for the sake of avoiding too complicated a picture, let's just say the corporation put up its own money or got it elsewhere. In any event, since the house is deductible to the corporation (presumably over the term of the lease), here's what happens.
Each year, the company deducts a part of the $80,000. Let's say we can get away with depreciating the property over 15 years -- saying that is the term of the lease. It makes economic sense (which doesn't mean it will actually fly, of course).
What happens is that each year the company deducts the 1/15th of $80,000. At a 40% tax rate, this deduction is worth $2,133 in extra cash. This amount can then be invested and compounds along with the other wealth-building components in this example. In 10 years, with compounding, you have $37,373. Plus, you have the house...or you will have it when the lease expires.
Can you really do this? Yes...but. In a similar case, the court has ruled that you could. Remember, however, these cases tend to turn on the details. Make sure you do it right.
Altogether so far, we've shown you how to get rid of the house in the suburbs and get a new house in a better area. This change alone could add a total of over $200,000 to your bottom line...the combined effect of eliminating your mortgage... owning a home that is rising in value...deducting the cost of the home...and getting the home for FREE at the expiration of the lease...
...and we still have not factored in the money you save from deducting the expense of utilities and maintenance. Suppose that cost is just $200 per month and that you pay taxes at a total rate of about 40%. Further suppose that you invest the savings (about $1,400 a year) at 10%. The bottom line of all this is an additional $25,000 or so.
About the Author Adam Starchild is a widely published author of books and articles on taxes, home businesses, and personal finance. The above article is reprinted with permission from his book How to Save on Your Taxes Without Cheating.
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