Hacker 2/HACKER2.mdf/secrets/ch19.txt

Text File | 1995-01-03 | 10KB | 173 lines

                     LET THE IRS PAY FOR YOUR NEW HOME

               Another strategy to consider when you purchase or
          sell a home is how you can take advantage of the
          deductibility of home mortgage interest.  This is one
          case where debt can be useful. But, briefly, the trick
          is to mortgage your property (especially at low
          interest rates) and then put the money into tax-free
          investments.  Thus, if you mortgage the property at
          6%...and put the money into tax-free investments
          yielding 6%...it looks like a wash. But you actually
          end up ahead. Say the amount is $100. Your mortgage
          costs you $6, which you deduct from your taxes. At a
          40% tax rate, the real cost of the $6 payment is only
          $3.60.  That is, it reduces your taxable income by
          $6...thereby sparing you $2.40 in taxes.  Plus, you get
          another $6 in tax-free interest.  Using this technique,
          you'll end up with $8.40 in tax-free earnings...or 8.4%
          tax free, instead of only 6%.  In other words, you
          increased your tax-free earnings by 40% with no
          increase in risk.
               If you sell a home for a $100,000 gain, and buy
          another one at the same price, using this trick you'll
          put $200 in your pocket, tax free, each month!
               While your home can, in a sense, be free to you
          because of its long-term wealth-generating potential,
          it can also be free for all the years you live in it --
          as you continue to build wealth. The key is to make
          your home a deductible expense.
               If moving away is just not possible for you right
          now, set up a business within your home. You can deduct
          some of your home expenses through the business.
               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, as we have
          seen, 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 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.
               We'll have a lot more to say about taxes in this
          book.  Because they are by far the biggest single item
          in most family budgets.  As such, they are also the
          most fertile field for growing your personal wealth by
          reducing the amount of taxes you pay.
               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.