[00:00:00] Hi, everyone. This is the how to lower your tax bill [00:00:10] podcast. I'm your host, Terrence Hutchins. I'm a financial and tax advisor in the Dallas Fort Worth area. And the goal of this podcast is to help you listeners get [00:00:20] educated on different tax strategies. That you can implement to improve your tax situation immediately? Each episode, we'll break down useful tax tips you can use to save [00:00:30] money no matter what your personal or business income situation. Because our motto is keep more of what you earn. So let's get into today's [00:00:40] episode. Welcome back to the how the lawyer tactical podcast. I'm your host, [00:00:50] Taren touches, and we have another episode for you, trying to keep more of what you earn. In fact, this week, if you are listening to this, when the show comes [00:01:00] out, The IRS has announced that they are starting to accept personal tax returns as of January the 27th. If you are a pass through entity, like a [00:01:10] partnership or an S Corp, your tax date is January 15th that they will start accepting returns. So the tax season is officially started. Obviously, you're probably not as excited [00:01:20] as me. But, today, we're going to help you figure out how you can lower your tax bill. So if you look at line 24 on your tax return. That's the line [00:01:30] that you will want to focus on and see how that number changes over time and how your income goes up or down. And so today we're going to focus on W-2 filers and just [00:01:40] how your personal residence can be utilized to lower your tax bill or to actually help you increase your income. So there's three main things I want to focus on, but before I want to get into [00:01:50] that, I want to talk about. A correction I wanted to make to our last podcast. Previously, we were talking about the passive activity loss rules and the fact that [00:02:00] if you make more than $150,000, the IRS will not allow you to deduct any losses from your real estate unless you're a real estate professional, which means [00:02:10] you work full time in real estate. I mentioned that you could use an IRA to reduce your income to hopefully get you below that 150 threshold. What I meant to say was [00:02:20] your 401k account. if you have a 401k account that will reduce your income that you could potentially add to that to reduce your income below the 150. So, I just want to make sure that we are accurate and what [00:02:30] information we are giving you. But as it relates to the house, I think there's three scenarios we want to hone in on. One is how does your primary residence lower your tax bill that's not [00:02:40] an investment at all. Two, how does your private residence lower your tax bill that you actually are using as an investment while you're living in it? And three, how do [00:02:50] you potentially lower your tax bill whenever you sell your property, whether it was an investment or it's always been your primary residence. So we'll dive into those three things. So first off, if [00:03:00] you bought your house many times you will go from being what's called a standard deduction filer to an itemized filer. So, simply put, the government says, Hey, if [00:03:10] you make a certain amount of income, you don't have to file a tax return. If you're single, that's about $14,000. If you're married, it's about $28,000. So, if you make less than that, they won't require you to file a [00:03:20] tax return. Which just means for everyone else that makes more than that, they don't tax you on the first $14,000 or $28,000 that you make. That's called your standard deduction. That number is subject to change [00:03:30] after 2025, so just be aware that that number could go down and we will provide information on that as well as other sources. However, your standard deduction is going to be [00:03:40] compared to what's called your itemized deductions, so the itemized deductions, which we've talked about a little bit before, but you're going to add up your property taxes, your interest on your house, your [00:03:50] medical expenses that exceed seven and a half percent your income, and then a few other things in your charitable contributions. And if those numbers equal more than twenty eight thousand or fourteen thousand if you're single, then you [00:04:00] can actually take that level of deduction. And so a lot of people that are buying houses in today's environment with higher interest rates, they'll see that their first year mortgage interest is probably $15,000 or [00:04:10] more. And if you're single, that definitely means, hey, you're going to be above the $14,000 threshold. So, you could go from taking the standard deduction the government gives you to [00:04:20] now itemizing. And so, when it comes to owning your house, there's a few specific things to your house. You have the real estate taxes. So, the property taxes that you pay, are going to be [00:04:30] deductible. Alright, so you want to make sure that you get your 1098 form, and sometimes they will show it on there, or you just need to keep your property tax bill. So, if you have MUD taxes, all those taxes that are related [00:04:40] to your property, you want to keep. And you can deduct up to $10,000 a year if you're married. $5,000 if you're married separately. So, with that benefit, it's $10,000 whether [00:04:50] you're single or you're married. You also have your interest. Your mortgage interest, you can actually deduct up to the first $750,000 of interest that you have. If your house was [00:05:00] prior to 2017, that number is at $1,000,000. So if I have a $700,000 mortgage and my interest is $30,000 a year, I can take the full amount. If my [00:05:10] mortgage is $800,000 and my interest is $35,000 I can only take the first $750,000. So normally there is a calculation that you have to do in your tax [00:05:20] software. either you're going to be working with a TaxPro or in something like TurboTax and It should do the calculation for you. And it's just going to calculate how much of that interest can you deduct. So it's going to add [00:05:30] those two numbers together. And generally we can get you to 10, 000 on real estate side. And then the interest. So hopefully that'll allow you to get above the threshold to where instead of you deducting $14,000 if [00:05:40] you're single or $28,000 if you're married, you might be able to deduct closer to $30,000 if you're single, maybe closer to 30, 40 or $50,000 if you're married, depending on your charitable giving as well. [00:05:50] So, that's one way when you own a property as your primary residence, you can deduct the interest and the taxes on your tax return. And one other thing to [00:06:00] point out, when you first buy the house, sometimes you do buy points. Those points are actually considered prepaid interest. So, if you buy points on your mortgage, you're going to want to make sure that you [00:06:10] deduct those, because that could be another $5, $6000, easily that you add to your deduction for that year. And if you miss out on that, you'd have to amend your tax return or you're just going to miss out [00:06:20] on the deduction and you're going to pay the government more than you should. So, if you own your private residence, I can optimize my deductions that can help me lower my tax bill. So, my taxable income [00:06:30] ends up being lower. Number two, sometimes you might buy your house and you use it as an investment. This is commonly referred to as house hacking. [00:06:40] So I live in part of the house. Let’s say it's a duplex. I live in one side. I ran out the other side or it could just be I rent a room. It could be on [00:06:50] Airbnb. It could be a long term rental. I get a roommate. Whatever the case is. When you do this, you now get to take the depreciation that we talked about on your house. And so you could be getting [00:07:00] income from your renter, and the depreciation might cover the cash flow that you're getting. And so that would allow you to create a tax loss and going back to my rules before, if your income is below [00:07:10] $150,000, you can deduct those losses against your income, your tax will get lower. If your income is above that, those losses are going to get carried forward to future years to basically offset [00:07:20] future real estate income or when you sell the property. If you're in that boat and you're house hacking, what you need to do is determine how much of the house Is considered [00:07:30] the rental portion. If you're in a duplex, it's pretty simple. You're just going to take the square footage of the unit. If it's your primary residence and you're renting a room, then you're going to try [00:07:40] to determine how much of the common areas have been isolated to your renter. And then if they have a specific room, so let's just say, for example, you have a four bedroom house, you rent out [00:07:50] one of the rooms. That's 25 percent right there. And then you can segment out a portion of the common areas that you say are exclusively for them. So, if they have their own bathroom, you include that. [00:08:00] If you give them a portion of the kitchen, let's say they have a pantry, you want to that square footage. And you're going to compare that to the total. So let's just say for easy math, your house is 2000 [00:08:10] square feet. And you determine that the business portion of The house that you're reading is a thousand square feet. So now that means 50 percent of all the [00:08:20] expenses related to the house can now be deducted. So that's going to be 50 percent of the real estate taxes, 50 percent of the interest, 50 percent of the insurance, your [00:08:30] HOA fees repair in general, all those are going to be deducted at 50 percent. And then if you have a direct expense, so let's just say, something happens to the [00:08:40] bathroom that's only used for business. If I have to repair that, I'm going to take a 100 percent of that because that's a 100 percent used for business. So, I'm going to now have to track what percentage of [00:08:50] use is business? What percentage use is personal? That's also related to the depreciation. So, the total depreciation is $5,000 and I use 50 percent for business. That means [00:09:00] $2,500 is going to be the depreciation expense on my schedule E on my personal tax return. So, if that creates a loss, I've just saved money in taxes or I [00:09:10] basically lowered my rent or I lowered my mortgage out of pocket expense because I'm collecting rent, but I might be able to not pay tax at all. So, my income is technically gone up, but my tax bill [00:09:20] stayed the same. So essentially, I lowered my tax bill as a result. now this gets complicated if you now decide to sell your property and some people do sell the [00:09:30] property if they live in it full time. So, when you live in your property full time and you sell it, the IRS has a test and they say, if you live in your house for two out of the [00:09:40] last five years, then you can sell your house tax free as long as the gain is not more than $250,000, if you're single or $500,000, if you're married. [00:09:50] So if you buy your house for 300, 000, if you're single and you sell it for $500,000, that $200,000 gain is tax free. One thing that you need to is you need to keep [00:10:00] track of the improvements you've made to the house, because over time, if you live in your house a while, or you just see a massive amount of appreciation, then you might exceed that $250,000 or [00:10:10] $500,000 amount. So, you're going to want to keep track of if I added a pool, if I did an addition, if I remodeled the floors or the kitchen, I'm going to want to keep track of [00:10:20] whatever cost I spent, because that's going to be added to the value of the house for tax purposes. So going back to my previous example, if you bought your house for $300,000 [00:10:30] and then you sell it for $600,000, well, now that $600,000 means you have a $300,000 gain. Well, if you put more than $50,000 in your house, [00:10:40] which would be the amount you had to pay tax on. Then you could say, hey, look, I put in a pool. That pool costs a hundred thousand dollars. So technically my house wasn't $300,000. It was [00:10:50] $400,000. So instead of my game being 300, 000, my game was actually $200,000 and I'm still below the threshold. If you're in that boat and you've only used your house as a primary [00:11:00] residence, then you will need to report it on your tax return in the year that you sell it. So, If you receive a 1099S form and that shows that you sold your house, you most definitely have [00:11:10] to file it on your tax return to make sure the IRS doesn't tax you on income that should be tax free. If you didn't get a 1099S, you should still report it just to acknowledge to the IRS that yes, I'm [00:11:20] selling my primary residence and I'm taking advantage of this exclusion, which can only be done every two years. So if I report this exclusion, I buy another [00:11:30] house, then I have two years to basically wait till I get the full deduction. it's important , specifically if you are like some people who first get [00:11:40] into real estate by buying their primary residence as a live in flip. They'll buy a fixer upper, they'll live in it as they're renovating it, and then they'll end up selling it [00:11:50] and take advantage of this exclusion where they don't pay any taxes on the gains. And then they try to space it out every two years so they don't have to pay tax. Now, if you're [00:12:00] not in that boat and you have to sell your house prior to the two years, you can get a partial exclusion if the reason you're selling your house is related to a [00:12:10] job relocation, health issues, or an unforeseen circumstance. So for example, I had a client who was. In a dispute with someone they were getting bullied by a neighbor and we [00:12:20] were able to prove that it was creating mental distress on the taxpayer. And so, because of that, they were able to file for this exclusion and their house had gone up, let's say [00:12:30] $100,000 over the year. And generally, that would have been taxable, but they were married and the IRS allowed them to exclude the 12 months that they were [00:12:40] in the house. So, they allowed them to exclude half of the $500,000 gain. So, if their gain had been more than $250,000, then they would have still paid tax. [00:12:50] But because it was less than $250,000, they lived in the house for a year, so they got 50 percent of the exclusion. They were able to exclude that $100,000 gain and move on to their next house. If you're in situations like [00:13:00] that, you want to make sure that you work with someone who has that experience, then kind of walk you through how to properly calculate that exclusion amount. Because sometimes it's not as clean as [00:13:10] just being 12 months and it's 50%. It could be slightly different. And so, you need to make sure that you get the right exclusion amount to make sure that you're not paying any taxes. If you're in that situation where you sell your house within a [00:13:20] year. You also have people that own the home and they convert it to a rental at that point the rule says that you do not have to have a consecutive period over the five year period so it [00:13:30] has to be two out of five years We have to own the house, and you have to live in it, but it doesn't have to be consecutive and so if you rent the house out Let's say I live in it for a year, I rent it out for a [00:13:40] year, I move back in for a year, and then I sell it. I still meet the 2 out of 5 years. However, generally it's, I move out of the house, and now it's a rental full time. You pretty much have 3 years to decide if [00:13:50] you want to sell it or not, and exclude the gain. there is a, somewhat ambiguous strategy where you could sell your house to yourself. And so some [00:14:00] people, if they could kind of justify the financial benefit, they will create an S corporation they will take their primary residence they'll sell it to the S corporation exclude the [00:14:10] gain on it, and now that S Corporation owns the house, and they can take the depreciation expense of the sale price, and they would have excluded the entire gain. So, if they decide they, don't [00:14:20] want to sell it, after 3 years or within 3 years, they can still have at least excluded the gain from the time that they converted it from a private residence to their rental. So that is a strategy [00:14:30] where you certainly want to work with someone who's qualified who can walk you through the ins and outs of that and to determine if that matches your situation. But it can be a way to increase your depreciation expense after [00:14:40] selling the house as well as excluding that gain so that if you eventually sell the house, you won't have to pay as much tax on the back end. Now, if you are in that situation where you [00:14:50] sell the house, but you had rented out for a couple of years, you will have to pay back the depreciation expense for the time that you took it while it was a rental. Same concept, if [00:15:00] it's a duplex and you live in one side and you rent out the other side and you decide to sell it, you can always exclude the gain portion that is attributed to when you lived in as your primary [00:15:10] residence. But the depreciation that is attributed to it being an investment, you will have to pay back in depreciation, recapture. So let's just say I buy my house. I live in it for two [00:15:20] years. I decide to rent it out and I sell it two years later. I took two years of depreciation expense. I'm gonna pay depreciation. Recapture on that. One strategy you could [00:15:30] consider is if that gain is big enough, you could do a 1031 exchange. So, if I don't want to pay tax on that depreciation recapture, I can roll that gain into a [00:15:40] new investment property, exclude the amount of the housing exclusion, and then the remaining amount, use that as a 1031 dollar. Let's just [00:15:50] look at a simple example. I buy a house for $200,000. I take $50,000 of depreciation, hypothetically, the math didn't work out, but just roll with me here. I sell that house for [00:16:00] $400,000. So, I have a, on paper, I bought it for $200,000 I depreciated it down to $150,000. I sell it for $400,000. I have a $250,000 gain. Well, my original purchase price of [00:16:10] $200,000, because it was my primary residence, that $200,000 of gain, I can exclude under Section 121 being it was my permanent residence, the $50,000 [00:16:20] of depreciation, I can roll that into a new investment property and I don't have to pay tax on that until I sold that new aggressive property as a component of a 1031 exchange. So, we'll get into 1031 exchanges on a [00:16:30] future episode, but that is another concept. If you were in that situation and you don't want to pay tax on that depreciation recapture, it is an option to consider if that is your situation. So, we've gone over a [00:16:40] lot today. We talked about how owning your home without investment considerations can lower your tax bill. We talked about how owning your home as a part [00:16:50] investment can lower your tax bill. And we talked about if you sell your house after owning it as a primary residence, how you can lower your tax bill in that dynamic, either. having done it fully as your [00:17:00] primary residence the whole time or having part of it being rental use. So hopefully you took away some good tax tips for that. And if it's specific to your [00:17:10] situation, you'll know some of the details that you'll have to review a little bit further to make sure that you're not paying more taxes than you should. So this week we're going to end with a [00:17:20] tax court case related To the investment interest deduction. So there was a couple back in the eighties that had bought some land and they were [00:17:30] trying to treat this land as if they were using it for land development and they treated the land development as a business. Well, when you have interest tied [00:17:40] to a business, then at the time, there wasn't the same level of deduction there is now. There's a little specific rules that are tied to a certain tax section, but I won't get [00:17:50] into that right now. But effectively, they were saying, hey, we bought this land. We're land developers. We have 10, 000 of interest every year. We want to deduct that interest as a [00:18:00] business expense. The IRS said, no, you can't do that. So, the taxpayer took them to the tax court. Tax court essentially sided with the IRS because they said these people had not done enough [00:18:10] to utilize this land for business purposes. And so, they actually classified them as owning it as an investment. And when you own something as an investment, you can deduct [00:18:20] the interest, but you can only deduct it up to the income that the investment produces. So, if they were trying to take a 10, 000 tax deduction and they'd have 10, 000 of [00:18:30] investment interest. Then they were limited on the amount of interest they could deduct the tax court sided with the IRS. So, it's important whenever you take a tax position, as we talked about before, that you [00:18:40] make sure that you can justify it. And if you are operating a business, you need to make sure that you have activities that back up the fact that you're actually trying to create a [00:18:50] profit from that activity. So, thanks for listening, share the show with someone as they're maybe navigating their tax filing this year. And remember to always keep more of what you [00:19:00] earn. I'll talk to you guys next week.