In delivering his semiannual report to Congress last month, Federal Reserve Chairman Alan Greenspan said he saw "signs of froth in some local markets where home prices seem to have risen to unsustainable levels."
Greenspan added that some regional markets appear to be charged "with speculative fervor."
If you're a real estate investment neophyte frothing at the mouth to capitalize on some hot properties, be careful. And no, I'm not talking about buying too high. If you're an amateur at this, you may make some moves that could cause an unexpected tax bite, warns Lonnie Davis, a certified public accountant and director of the Philadelphia-based CBIZ Accounting, Tax & Advisory Services.
One of the biggest mistakes amateur real estate investors are making is misinterpreting Internal Revenue Code 121, Davis said.
Under this portion of the tax code, homeowners can keep a gain of up to $250,000 ($500,000 per married couple filing jointly) tax-free when selling their principal residence.
However, people often think they are entitled to this tax exclusion when they're not.
For example, let's say you build a home and it appreciates so greatly that you decide to capitalize on the gain by selling the property without ever moving in. Are you eligible for the IRS Code 121?
The answer is no.
To qualify for the tax exemption, you must have owned and occupied your residence two of the five years before the sale. The time spent at the home need not be consecutive, but it must be a total of 730 days, Davis said.
Taking the same example, suppose you know you don't qualify for IRS Code 121 but you've heard of a "like-kind" tax-deferred exchange. Generally, if you exchange an investment property for another investment property of the same or greater value, no gain or loss is recognized at that time under Internal Revenue Code 1031. You will, however, have to pay taxes eventually if you sell the property and don't make another exchange.
So, using the same example, if you build a home and sell it without moving in, could you defer paying tax on any gain if you buy a home of equal or greater value that you intend to live in as your principal residence?
Again the answer is no, Davis said.
Personal assets, including personal homes, do not qualify for Section 1031 treatment. Only assets that are rental properties or properties held for investment do, Davis pointed out.
Here are the two most common like-kind exchanges, according to Davis:
* A non-simultaneous, or Starker, exchange (named for the man who won a court case to allow this type of deal). This requires the property to be acquired to be identified within 45 days of the sale of the old property. The sale must be closed within 180 days. The seller may not receive sale proceeds. Instead, the funds must be placed in escrow or with a qualified intermediary, pending the acquisition of the new property. "Even if the seller meets the timing requirements, they will fail 1031 if they are in receipt of the funds," Davis said.
* A reverse, or Reverse Starker, exchange. This occurs when the seller acquires the new property prior to selling the old property. Essentially the exchange process works in reverse. However, this is a complex transaction and you will need professional help.
In general, Davis said, here are the most common tax mistakes real estate neophytes make:
* Assuming that all transactions will be long-term capital gain and taxed at 15 percent or less.
* Thinking they can roll proceeds from one sale to another and avoid paying any taxes without following the strict rules in the tax code.
* Buying and selling properties too often. The IRS could rule that your real estate investing is really your trade or business, and therefore any money you earn would be taxed as ordinary income. "This is a hot-button issue with the IRS," Davis said. "The more you do in this area, the more likely the IRS will say it's not an investment but that you're a dealer in real property."
* Not properly tracking your real estate expenses, including improvement costs. Use separate bank accounts to keep track of your expenses. "A lot of people not involved in real estate as a full-time job are haphazard and don't take advantage of all their deductible costs," Davis said.
I know it sounds obvious, but consult with a tax professional to ensure that you understand all your tax liabilities before your real estate purchase or sale.
In the real estate business, you've probably heard that it is all about location, location, location. That's only partly true. If you don't want the IRS to come after you, you'd better understand the taxation, taxation, taxation of your real estate transaction.
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