Many Active Duty Military Members and Retirees end up with rental Real Estate (of course lots of other people do too).  It is one of the many consequences of short-notice PCS moves or PCS moves during depressed Real Estate cycles.  But with that Real Estate comes a looming tax bill....but that tax bill can be avoided with proper planning.

What Do You Mean I Have a Tax Bill?  I'm Losing Money!

Most of us remember a time when people made money on real estate.  But there are situations where even if you are losing money or if the house qualifies as your primary residence you could still have a tax bill.  There are three scenarios where you will owe taxes, and two of them you may think you are off scott-free.

1. The House sells for more than the adjusted basis of the house (calculating basis is a topic for another day and isn't always price + improvements).
• You owe Capital Gains Tax on the amount the selling price exceeds the adjusted basis
• You owe Tax on Depreciation Recapture (the amount you depreciated or should have depreciated the property)
• You may owe ObamaCare Medicare Surtaxes as well (on both the Capital Gain and Depreciation Recapture).
2. The house sells for less than the adjusted basis
• You owe Tax on Depreciation Recapture
• You may owe ObamaCare Taxes on the Depreciation Recapture
3. You lived in the house enough to qualify it as your primary residence (either with or without special military rules) and you sell for more than the adjusted basis
   • You owe Tax on Depreciation Recapture
   • You may owe ObamaCare Taxes on the Depreciation Recapture
   • You will NOT owe Capital Gains Tax on the amount the selling price exceeds the adjusted basis

Help!

You can defer taxes on the sale by doing what is called a 1031 Exchange (sometimes called a Starker Exchange).  In a 1031 Exchange you exchange your rental property for a like-kind property and defer the taxes.  The rules for a 1031 exchange are complicated, but you don't have to physically exchange properties.  You can sell and then buy a new property.  There are some rules...

1. You can't take out any cash and your loan must equal or exceed the amount of your current loan
2. You must use a qualified custodian to receive the funds...you can't touch them
3. You must identify the new property within 45 days of closing on your property
4. You must close on your new property within 180 days of selling the previous rental

If you do these things (get competent advice) you defer the gain and depreciation recapture and the basis of the new property will be reduced by the amount of depreciation you defer.

Wait!  That is Only Postponing the Problem

True, the tax has only been deferred.  But there is a way to never pay the taxes...Let's look at one scenario

1. You own a Rental Property outside Podunk AFB.  You never plan to return there to live.  You want to sell the house, but you don't want to pay the taxes.
2. You've always wanted a Vacation Condo on the Beach
3. You sell the Rental and buy a Vacation Condo via a 1031 exchange.
4. You set the Vacation Condo up as a rental.  You can even use it a few days yourself (rules vary).
5. You maintain the property as a rental for a minimum amount of time (usually one year) and until you no longer need the rent to pay the mortgage/expenses.
6. You fix it up and use it as a Vacation Home
7. Here is the key...you own it until you die
   • At the time of your death the basis of the house steps-up to the Fair Market Value at the time of death (current law)
   • The House is sold with no Income Tax or ObamaCare Surtax (there could be estate taxes and probate fees) or the heirs keep it to use and never owe taxes on the amount shielded by the step-up rules.

Prior Planning Prevents....

There are limitations to how much you can affect your tax bill.  But, here is one way where you might be able to stick it to the man and get your dream vacation home too!  Plan first, pay taxes second...

• Tuition and fees are covered in full.
• Room and board, if the student is enrolled at least half time. But such expense must be not more than the greater of (1) the allowance for room and board, as determined by the school, that was included in the cost of attendance; or (2) the actual amount charged if the student is residing in housing owned or operated by the school.
• Food. If you spend a certain amount for a meal plan, that entire amount can be deducted, even if used for coffee or ice cream and not a full meal. Weekend meals can also be included if the dining halls are not open.
• Books and supplies. Any fees associated with purchasing school textbooks are considered qualified, as are required equipment or supplies such as notebooks and writing tools.
• Computers/laptops, but only if required by the school. If required, Internet fees and PDAs or "smart phones" may also qualify.
• Special-needs services required by special-needs students that are incurred in connection with enrollment or attendance at school.

 What's Not Covered

• Student loans. Interest on or repayment of student loans is not considered a qualified expense by the IRS.
• Insurance, sports or club activity fees, and many other types of fees that may be charged to students but are not required as a condition of enrollment.
• Transportation to and from school.
• Concert tickets or other entertainment costs, unless attendance is requisite to a course or curriculum.

Note that expenses must apply to a qualified college, university, or vocational school for post-secondary educational expenses. Also keep in mind that taxes and a possible 10% penalty will apply to all distributions that are not considered qualified educational expenses by the IRS, so be sure to check first.

When tapping your 529 account, be sure to avoid taking too much or too little.

• If you take too much: The excess will be classified as a nonqualified distribution. You or your beneficiary will have to report taxable income and pay a 10% federal penalty tax on the earnings portion of the nonqualified distribution. The principal portion is not subject to tax or penalty.
• If you take too little: If your child graduates and does not attend post-graduate school -- or if you do not have another child you can change the beneficiary designation to -- you'll be left with a 529 account that, if used for any other purpose, will incur tax and a 10% penalty. If you have a substantial balance left in your 529 account, consider tapping the account at the earliest tax-free opportunity.

Also be sure to coordinate with other family members who may have funded 529 plans for your child to help determine which accounts should be used first.

Source/Disclaimer:

¹Investing in 529 plans involves risk, including loss of principal. By investing in a 529 plan outside of the state in which you pay taxes, you may lose the tax benefits offered by that state's plan. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary.

Before you invest in a 529 plan, request the plan's official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses, and the risks of investing in a 529 plan, which you should carefully consider before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's 529 plan. Section 529 plans are not guaranteed by any state or federal agency.

This communication is not intended to be tax advice and should not be treated as such. Each individual's tax situation is different. You should contact your tax professional to discuss your personal situation.

Required Attribution

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