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Second Homes – Tax Benefits and Potential Tax Pitfalls

Many people are buying a second home. They might do so to have a vacation home with the possibility of selling it at a substantial gain in the future. Another reason people buy a second home is to use it in the future as a primary home, perhaps in retirement. They might prefer to purchase the second home now to avoid the possibility of having to pay considerably more for it in the future.

What are the tax benefits and potential tax pitfalls in purchasing a second home? The first benefit is that the real estate taxes on a second home are deductible as an itemized deduction. However, a potential pitfall exists if the taxpayer is subject to the alternative minimum tax (AMT). Real real estate taxes are not deductible for AMT purposes.

The mortgage interest is also deductible as an itemized deduction on mortgage loans up to a maximum of $1,000,000 on loans used to acquire, construct, or substantially improve the taxpayer's primary home and the taxpayer's second qualified home. A refinancing of acquisition debt is considered acquisition debt to the extent that it does not exceed the balance before refinancing.

Another tax benefit for owning a second home is that the taxpayer may deduct interest on home-equity loans up to a maximum loan amount of $100,000. A home-equity loan is considered as an acquisition debt if the taxpayer uses it to make a substantial improvement to the primary home or second home. The loans may be secured by the primary residence and/or the second home. For tax purposes, a home-equity loan includes the excess of the balance of a refinanced acquisition loan over the balance before the refinancing unless the taxpayer uses the excess to make a substantial improvement to the home.

A tax pitfall is that the interest on a home-equity loan is generally not deductible for AMT purposes. An exception applies if the taxpayer uses the proceeds of the loan of the loan to make a substantial improvement to the property.

If a taxpayer rents a second home to a tenant for 14 or fewer days during the year, the rent income is not taxable. The taxpayer may still deduct the real estate taxes. The taxpayer may deduct the qualified mortgage interest as long as the taxpayer used the second home for personal purposes for a number of days that exceeds the greater of 14 days or 10 percent of the number of days the taxpayer rented the house to a tenant at a fair rental. If the taxpayer does not meet this test, the second home might be considered as rental property.

A potential tax pitfall on a second home is that any gain on the sale of a home that is not the taxpayer's principal residence is taxable. It would be taxable as a capital gain because a personal use asset such as a second home is a capital asset.

The exclusion of gain up to $250,000 ($500,000 on a joint return) on the sale of the taxpayer's home applies only to the sale of a home that that the taxpayer owned and used as the taxpayer's principal residence for at least two of the five years before its sale. A taxpayer may have only one principal residence at a time.

A taxpayer could sell the primary home and exclude the gain up to the limit and then move into the second home and use it as a primary residence for at at least two of the five years before the taxpayer sells it. By doing so, the taxpayer could use the exclusion of gain provision on both homes. The potential to exclude the gain on the sale of both homes up to the limit using this strategy is a major tax benefit.

Another potential tax pitfall on owning a second home is that any loss on the sale of a home used as the taxpayer's residence, whether as a primary home or as a second home, is not deductible because the loss is on the sale of an asset used for personal purposes.

An individual should consider many factors before buying a second home, such as cost, convenience, and potential gain. The tax benefits and potential tax pitfalls are some other key factors to consider before buying a second home.

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Trader Tax Status

Trader Tax Status! Those three magical words that convert trading activity into the best
of all possible worlds.

If you actively trade financial products (securities, commodities, futures, and currencies)
with the intention of making a living, you may qualify for business treatment with trader
tax status.

From a tax point of view, investors are not treated very well under our tax laws as they
are now constituted.

That's because investing is not considered a business activity and, therefore, not
entitled to the tax advantages available to businesses.

You may call yourself a trader but unless the IRS recognizes you as such you are an
investor just like everyone else. And that means you're stuck with limitations on capital
losses, wash sale rule deferrals, and non-deductibility of trading expenses unless you
itemize, and then only after further limitations. Of course, your gains will be fully
taxed!

However, if you conduct your trading activity in such a manner that it rises to the level
of a business, all kinds of tax advantages suddenly open up to you almost as if by magic,
generating average tax savings well over $10,000 per year.

But there is a catch (isn't there always?). The tax code contains no actual definition of
trader tax status. The IRS has issued guidelines but mostly everything is decided by case
law. In other words, each case is decided on its own merits.

Here's the situation: Investment securities are generally considered to be capital assets
in the hands of whomever owns them. As such, upon sale or other disposition they receive
capital gain or loss treatment, not ordinary income or expense.

Basically there are three recognized categories of activity involving investment
securities: (1) Securities dealers, (2) Exchange traders (market makers, floor traders,
etc.), and (3) Investors.

Securities dealers buy securities (stocks and bonds) from corporate issuers and resell
them to customers (investors). They are middle men, much the same as car dealers that buy
cars from auto manufacturers, take them into inventory, and resell them to the car buying
public.

In the hands of securities dealers, stocks and bonds are not capital assets to be held
for investment but are simply merchandise for resale to customers in the ordinary course
of business. They are clearly in the investment securities business.

Exchange traders, market makers, floor (and off-floor) traders trade for their own account
and risk. They trade for a living. They are clearly in the trading business.

Investors, on the other hand, hold investments for income and long term growth in value.
Although they are free to sell whenever they wish, they are clearly not in the
business of doing so and, therefore, not entitled to business treatment of their
losses and expenses no matter how much time they may devote to nor expense incurred in
their investing activity.

The computer age and the internet has brought about an explosion of trading activity that
has, in many cases, enabled participants to claim trader tax status the same as floor (and
off-floor) traders on an exchange.

It is absolutely vital that you engage the services of competent professionals that
specialize in trader tax status matters.

Walk into any national chain of tax offices and ask about "trader tax status", "mark-to-
market accounting" (MTM), "net operating losses" and in almost every instance you will
get a blank stare from a tax preparer who doesn't have a clue about these laws and
benefits.

Ask your local CPA or tax attorney and they may know a little about it but probably not
much. Many law and accounting firms have not shown much interest in the small business
trader. The larger firms prefer to cater to the interests, research, and practices of
large corporations and public companies.

Trader tax status laws are complex and vague, with many nuances, most of which require
professional judgement based on specialization. Unless a CPA or tax attorney handles
many trader tax status clients, their advice will probably be inadequate.

Real Estate Tax – Tax Maps, Real Estate Tax Exemptions, Estate Tax Lien Information and More

The history of real estate tax and property tax can be traced back to Colonial America. Land was taxed on a per-acre basis until the nineteenth century when uniformity clauses were adopted to help protect settlers. The uniformity clauses now require that property be taxed according to its value.

Illinois was the first state to adopt this clause, and some states such as Tennessee adopted additional provisions that exempted products produced from the soil and up to one thousand dollars of personal property. Elected officials would assess the market value of the property, collect taxes due, and turn the money over to the proper government (school districts, special districts for fire prevention, irrigation, etc.).

It wasn't until 1907 that the National Tax Association was founded, and declared that trained professionals perform all assessments of real estate for tax purposes. This regulation curtailed favoritism and promoted equality.

PROPERTY ASSESSOR AND REAL ESTATE TAX MAPS

In the twenty-first century, state governments depend more on income and sales taxes than on property taxes for funding. Local governments still rely on a small percentage of property taxes to generate revenue. The tax assessment is based on the value of the building and the value of the land it occupies. The assessor maintains accurate "tax maps" which identify individual properties to ensure they are not taxed more than once.

Any improvements made to the structure or land will be noted on these maps. Methods used to calculate value of property have changed since colonial times. Assessors may now choose between the income approach, market value, or replacement cost. All values determined by the assessor are subject to a "second opinion" via administrative or judicial review. Once the value of the property is agreed upon, the assessor will multiply this value by the established tax rate to calculate how much you owe in taxes.

HOMESTEAD REAL ESTATE TAX EXEMPTION

Some states have passed laws to provide homestead exemptions to put limitations on how high property taxes may be raised. This exemption is only available to residents of these states in which the property in question is the primary residence. You cannot use a rental property or second home in a different state as your "primary residence" to receive this tax break. Once the property is sold, the exemption is removed and property taxes may rise for the new owner based on the purchase price of the home.

DELINQUENT REAL ESTATE TAX PENALTIES (APRIL 1ST)

Failure to pay your taxes by April 1st each year will result in a delinquent real estate tax. Penalties for delinquent taxes may vary by state. In some states you will be charged a ten percent penalty on all unpaid taxes and will be charged an additional administrative processing fee.

If after the beginning of June you still have not paid your delinquent real estate taxes, your property will become tax defaulted. At this time you will begin to accrue additional penalties for each month that your taxes remain unpaid. If you continue to refuse paying delinquent taxes, the Tax Collector may appeal to the Court to seize and sell your property.

LIEN ON PROPERTY AND TAX CERTIFICATES

A lien may be placed on the house through the purchase of a tax certificate, and the owner can only remove the lien by paying the required taxes due. After a period of two years, the holder of the tax certificate may request a tax deed application. This application allows the certificate holder to sell your property at a public auction. The only way to prevent losing your property is to pay all delinquent taxes and applicable fees that have accumulated.

ESTATE TAX LIEN AND AFFIDAVIT TO REMOVE TAX

Some states such as Massachusetts will put an estate tax lien on property after the death of the owner, or anyone else who may have had a legal interest in the property (i.e. spouse). This usually occurs in the absence of probate and when the gross estate value does not exceed $1.5 million. Estates worth more than this limit will be subjected to federal estate tax filing.

Barring the above exceptions, an estate tax lien may be removed by filing an Affidavit. The Affidavit may be filed by an Executor or anyone in possession of the deceased's property (i.e. spouse). An Affidavit must contain key information such as:

1. Full name and date of death for the deceased

2. Documentation that the estate does not require federal estate state filing

3. The identity and title of the person signing the Affidavit and the form must be notarized

4. The death certificate

5. Any applicable recording fees for the Affidavit and death certificate

Where is the Best Place to Invest?

Where is the best place to invest in tax lien certificates or tax deeds? Most people are concerned about which lien states have the highest interest rates and which deed states start bidding at back taxes. I believe that the best place to start investing is in your own backyard. I think that it's best to invest in an area that you know, because you'll know what the property values are and you'll know what to look out for. Each state has different problems that you have to be aware of, especially if you're purchasing raw land.

In Pennsylvania where I invest in tax deeds, for example, I have to worry about whether a property will perk or not. If I buy a lot in a deed sale that doesn't perk I won't be able to get a septic design approved and won't be able to build on the property. Its resale value will be a fraction of the price that I could get for it if it had an approved septic design. In another state you might have other concerns. In dry states, like Arizona for example, you may have to be concerned about water rights.

Don't be too concerned about which state has the highest interest rate. In states with high interest rates, the interest is typically bid down extremely low. What you should be concerned about is will you have the opportunity to pay the subsequent taxes, and will you get the maximum interest rate on your subs, and are there other penalties that you are entitled to.

In New Jersey, for example the interest rate is typically bid down to 0% and then premium can be bid as well. The reason that investors do this is because they know that once they have the lien, they can pay the subsequent taxes and get the maximum interest rate on their "subs," which is 18%, and they will also receive a penalty on the certificate amount of the lien.

In Florida where the maximum interest rate is also 18%, the interest is typically bid down to as low as

Debunking the Incorporation Tax Myths

Most weeks my CPA firm offices take a telephone call from a new small business owner looking for a tax accountant. Usually, after some chit-chat, the caller gets up the courage to ask awkwardly about those barely legal ways the savvy businessperson can reduce taxes by incorporating.

I always try to be friendly as this conversation unfolds. Hey, I know the score. This entrepreneurial newbie has at some point in the past heard and then believed one or more of the urban tax myths about how corporations save small businesses tax.

Now make no mistake: Incorporation can be an excellent business decision. Incorporating a business always reduces the business owner's legal liability at least a little bit. And incorporating a business can sometimes reduce some of the taxes a business pays (such as payroll taxes). But incorporation doesn't magically save a business owner from paying taxes. In particular, entrepreneurs and business people should not fall for three urban myths about taxes...

Incorporation Tax Myth #1: Extra Tax Deductions

The most common tax myth may just be that by incorporating, a business owner receives extra tax deductions. Like many myths, there's a grain of truth here. But business owners should know that, for the most part, tax laws allow a business to deduct any ordinary or necessary expense.

The definition of what's "ordinary and necessary" doesn't change because one business operates as a corporation or another business operates as a sole proprietorship.

For example, a small business operating as a sole proprietorship doesn't get to deduct extra amounts or personal expenditures merely because the proprietor incorporates.

And that means you shouldn't incorporate a new or ongoing venture on the basis of the "extra deductions" myth.

Incorporation Tax Myth #2: Avoiding State Income Taxes

Many entrepreneurs in high tax states want to believe another common myth... the myth that incorporating in another low-tax or no-tax state will save taxes. For example, many California businesses want or would like to believe that incorporating their business in Nevada means the business doesn't have to pay California state income taxes.

One understands the source of this myth. A Nevada corporation operating in Nevada doesn't have to pay state income taxes. Yet a California corporation operating in California does have to pay state income taxes. Why can't a California entrepreneur incorporate his business in Nevada? Won't that allow the business to avoid California state income taxes?

Unfortunately, no.

Here's why: The state of incorporation doesn't determine which state's tax laws apply. What matters is the state or states in which a business operates. For example, if a Nevada corporation operates 100% in California, California gets to tax 100% of the income earned by the Nevada corporation. Similarly, if a California corporation operates entirely in Nevada, California doesn't get to tax the income earned by the corporation. Nevada does--or at least Nevada could tax the income if it chooses to.

The bottom-line? You should not incorporate in another state as a way to save state income taxes. The technique doesn't work.

Note: Another related technique does work and deserves mention: You can move your business to a low-tax state, begin operating from that state, and then save state income taxes that way.

Incorporation Tax Myth #3: Sheltering Income from Taxes

One final and somewhat odd myth about incorporation deserves busting...

Some new business owners understand that if a corporation earns profit but doesn't pay out that profit to the shareholders, the shareholders don't have to pay income taxes. This bit of trivia sometimes triggers the idea that maybe a shareholder can shelter income by "leaving" cash inside the corporation.

What this myth gets wrong is that while a business owner can avoid personal income taxes by leaving profits inside the corporation, the corporation then gets taxed on those profits. In this case, the business owner hasn't really reduced the taxes levied on his or her entrepreneurial activities. Rather, he or she has in effect written the check from a different bank account.

And another facet of using a corporation to shelter income from taxes should be mentioned. When the shareholder moves the money out of the corporation, he or she will pay taxes on the dividends. When one combines the corporate income taxes paid by leaving money in the corporation and the later dividends tax paid by the individual, the pursuing incorporation myth #3 may actually cost the entrepreneur more in taxes.

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