After working hard for so many years, you finally bought your dream house. Do you know that you have also just landed onto a trifecta of tax saving haven?
Mortgage interest deduction
You can claim this deduction if you take out mortgage loans to buy up to two houses! One for your first primary residence and the other for your second vacation home that you can usually rent out to generate more income! However, you can only deduct the interests attributable to the first $1 million home acquisition indebtedness plus the first $100,000 home equity indebtedness of both houses combined, not per house.
The catch: you generally have to claim itemized deductions in order to get this mortgage interest deduction.
Section 121 exclusion of gain
Let’s say you don’t like your dream house that much anymore and want to sell it, and assume further than you will make a huge profit off the sale. There is a tax break for you to take advantage of after the sale. Here’s how it works.
You qualify for the tax break if you own and occupy the house as a principal residence for two of the five years immediately before the sale. If you are single, you can exclude up to $250,000 of the profit from taxes. If you are married and your tax filing status is married filing jointly, you can exclude up to $500,000 of the profit from taxes.
The catch: you can only claim this exclusion once every two years. Certain situations will cause a reduction to the exclusion amounts.
Zero tax on the gain
Let’s say you sold the dream house, excluded a big chunk of profit thanks to the section 121 exclusion rules, and you ended up with a sizable profit. Wouldn’t it be nice if you STILL don’t have to pay any taxes on the profit?
Assume that you own the house for longer than one year, any profit leftover from applying the section 121 exclusion the profit from the sale can be classified as Long Term Capital Gain and its tax rate is 0% if your total income (excluding the profit) falls into the 10% or 15% income tax bracket. This rule applies even if you are a foreigner (no US green card, no US citizenship).
The catch: California residents must pay real estate tax withholding up front, and then file a California income tax return to claim the refund.
Cautionary tale for foreign homeowners
If the seller is a foreign person, a federal real estate tax withholding is also required on top of the state withholding. The foreign seller must file a federal income tax return to claim the refund.
If the foreign seller doesn’t already have an ITIN (individual tax identification number), please ask and insist the escrow company helps the seller apply for one before closing the escrow. This ITIN is a crucial piece of information that must be put on the real estate tax withholding forms so that refunds can be issued to the seller. Without this ITIN, no refunds can be issued even if money were already withheld and paid.
I learnt this lesson the hard way. A foreign client sold a house using an escrow company who neglected to obtain an ITIN during the escrow closing process. As a result, the real estate tax withholding forms did not have ITINs on them and the tax agencies refused to issue the refunds. The burden shifted to me, the CPA who prepared the tax returns. It took me nine months to sort things out and eventually got a refund back from the IRS. The state refund took even longer.
Remember, a foreign seller MUST have an ITIN before closing a house sale. Don’t repeat the painful history that I had.
Jimmy W. Wong, CPA left the comfort and stability of Corporate America and started his own consulting firm with a true passion to help business owners succeed in their endeavors. He is a certified public accountant, an IRS enrolled agent, and a member of the American Institute of CPAs.
Jimmy graduated from California State Polytechnic University Pomona with a Bachelor’s Degree in Accounting. He is currently studying for a Master’s Degree in Business Taxation at the University of Southern California.