How Are U.S. Primary Residences and Investment Properties Treated Differently for Tax Filing?
January 14, 2024 Evelyn Yang recommends
In the United States, if you own two properties, one is generally considered your primary residence and the other an investment property. Primary residences and investment properties are treated differently under tax policy. Are there ways to reduce taxes when filing taxes for these two types of property? Let’s learn about them today!
How Are Primary Residences and Investment Properties Defined?
The basic residence of each married household or single individual is the primary residence (Principal Residence or Primary Residence), as distinguished from other residences, such as investment rental properties and vacation condominiums.
Under tax law, if a taxpayer owns two residences at the same time, the residence in which the taxpayer lives for a relatively longer period is the principal residence, or primary residence. The other property is generally considered an investment property or vacation home.
Tax Benefits When Filing for a Primary Residence
1. If the property is a primary residence and was purchased with a loan, all expenses related to the primary residence may be deducted when filing taxes, such as mortgage interest, loan points, property taxes, and so on. This amounts to a significant tax benefit for the homebuyer.
2. If a taxpayer sells a primary residence, capital gains tax must be paid. However, if the owner selling the primary residence lived in that residence for at least two years during the previous five years, no capital gains tax is due on the portion of the home-sale profit below $250,000 for an individual or below $500,000 for a married couple.
After a taxpayer declares a property as a primary residence, the Internal Revenue Service will periodically check the taxpayer’s utility usage records, bill payments, whether the taxpayer exercises voting rights in the residential area, and a series of other circumstances that can show whether the taxpayer regularly resides at the property. Therefore, it is difficult for a taxpayer to falsely report the status of a primary residence.
Tax Benefits When Reporting Rental Income From an Investment Property
First, owners must keep receipts for expenses incurred to repair rental properties, because these receipts can be treated as expenses when filing taxes and used to offset rental income. If workers are hired, owners are also advised to download Form 1099 from the IRS website so that payments made to workers can be used when filing taxes. Many Chinese people prefer to pay workers in cash to obtain lower charges, but doing so not only leaves no documentation for tax filing, it also prevents them from claiming rental-property costs to offset rental income.
Another tax-saving strategy for rental properties is depreciation recapture. Only the value of the house can be depreciated; the land value cannot be depreciated. A rental property is depreciated over 27.5 years. For example, suppose you buy a house for $200,000, the land is worth $40,000, and the house itself is worth $160,000. Each year, you can depreciate $160,000/27.5 = $5,818, which is deducted from rental income. After 27.5 years, you will have fully depreciated the $160,000. If you then sell the house for $300,000, you must pay long-term capital gains tax on the $100,000 appreciation, at a relatively low tax rate. However, the $160,000 in depreciation that previously helped you save taxes must be taxed again. This tax is called depreciation recapture.
Experts say that many owners forgo depreciation, which is not entirely correct. Because a house may be rented for decades, it is difficult for the IRS to determine whether depreciation was claimed to offset taxes, so tax law provides that both depreciation already taken and depreciation that could have been taken must be recaptured. Since there is no reason not to take it, giving up depreciation and suffering an unnecessary loss is not worthwhile. In addition, money continues to lose value: a $200,000 house 30 years ago may now be worth several times as much. The taxes saved through depreciation at that time, calculated using today’s prices, may increase five- to tenfold. Therefore, it is recommended that depreciation be taken as early as possible.
What Are the Consequences of Not Filing Taxes?
If a taxpayer owes taxes to the U.S. government and does not pay by the tax deadline, the taxpayer will be fined by the IRS and charged high interest. IRS rules provide that if U.S. taxes are filed late and taxes owed to the IRS remain unpaid, three types of penalties may arise: a failure-to-file penalty, a failure-to-pay penalty, and late-payment interest.
Therefore, filing and paying taxes on time is very important. For non-U.S. tax residents, especially those who own property and have financial investments in the United States, properly filing U.S. taxes is an important factor in ensuring that their financial interests in the United States are not disrupted. It can also ensure that their U.S. investment income is taxed only at a reasonable rate. The IRS provides detailed explanations regarding tax filing for non-U.S. residents and, with respect to certain investments, gives non-U.S. residents the right to choose how to handle their taxes.
In addition, properly reporting U.S. income taxes for non-U.S. residents is widely considered an optimal approach. It not only demonstrates that non-U.S. residents strictly comply with U.S. law, but also ensures that they are taxed only at a reasonable rate. For non-U.S. residents who have income in the United States, filing taxes properly is a very correct way to handle the matter.
Furthermore, for non-U.S. residents, properly reporting and paying taxes on U.S. income can largely help avoid random IRS tax reviews and audits. If selected for an IRS audit and determined to have failed to pay taxes on time or evaded taxes, the taxpayer may not only face substantial penalties; property in the United States may also be affected.
At the same time, IRS records have a certain connection with visa applications at U.S. embassies. The U.S. visa application requires applicants to enter a U.S. individual tax identification number. Therefore, a poor tax-filing record can greatly affect a subsequent U.S. visa application, while a good tax-filing record can help a nonresident obtain a U.S. visa again.
Consider a “1031” Tax-Deferred Exchange When Changing Properties
“1031” is Section 1031 of the U.S. tax code. Its full English name is “Internal Revenue Code Section 1031,” and it is also called a “Starker Exchange.” Starker was the name of an investor who bought and sold investment property. At that time, the IRS collected capital gains tax from him on a property he sold. However, he believed that because he immediately used the sale proceeds to buy another investment property, he should not have to pay tax until he eventually sold the last property. He therefore brought a lawsuit to the U.S. Supreme Court and ultimately won. The U.S. Congress subsequently enacted the legislation known as “1031.”
Therefore, under “1031,” if an investor sells an old property, called the Relinquished Property, and uses the proceeds to buy another property, called the Replacement Property, the profit may temporarily remain untaxed (Tax Deferred).
The specific procedure is as follows: After selling the old property, the investor must find another property within 45 days and sign a purchase contract, then close within 180 days. The investor cannot use the sale proceeds; they must be placed with an intermediary called a “Qualified Intermediary.” When purchasing the other property, the funds are transferred directly into the second property. The second property and the first property should be “like-kind” properties, meaning investment property.
There Are Advantages to Choosing Whose Name to Use for the Investment
If an investment property is purchased in an individual’s name, taxes can be offset through the property’s property taxes, insurance premiums, depreciation, renovation and repair expenses, real estate company management fees, and real estate brokerage commissions. For high-income earners, the tax savings can be as much as 40% of federal taxes, equivalent to the government covering half of the expenses for you.
If real estate is purchased in a company’s name, in addition to the deductions mentioned above, all expenses required for the company’s rent, telephone, daily maintenance, and daily management, as well as all employee wages and benefits, and computers, furniture, appliances, and other items purchased in the company’s name, can all be deducted. Experts recommend remembering to retain original invoices, receipts, or letters as documentation for tax filing.
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