Brad Konishi, CPA
Did you just purchase a home? Congratulations!
Whether this is your first home purchase, or you've done this many times in the past, congratulations on your purchase! I've been teaching real estate tax classes since 2004, and I have operated a tax practice specializing in real estate taxation since 2009, so I've learned quite a bit about how to implement wise real estate tax strategies and how to avoid mistakes. Here are some of the things I've observed that may be relevant for research further and a discussion with a qualified tax professional:
Purchasing a Principal Residence
When buying a home to live in, it's sometimes foreign to buyers to think of it as an investment. It's a place where you and your family seek comfort after a long day. It's a place where cherished memories are made, so it seems a little cold and sterile to consider your home like a portfolio asset, but it is. For many people, their home is probably their most valuable financial asset.
If you make improvements to your home, keep those invoices and retain your proof of payment. If you ever sell the home and you want to minimize your tax on the sale, it helps to make sure your "tax basis" is as high as legally allowed in order to minimize your potential for taxation. Improvements add to your basis, but if your tax returns are ever audited, you'd probably be asked to provide evidence, so store the invoices and proof of payment in a secure location. Even better, make electronic backups in case your records are ever lost or destroyed.
There is a tax rule in the Internal Revenue Code (also followed by Hawaii) that gives a tremendous benefit to people who sell their principal residence. The rule is called the "main home gain exclusion", also known as Section 121, and it's simple - only 3 criteria need to be met to be able to avoid taxation on the gain up to $250,000 ($500,000 for couples married filing jointly):
In the 5 year period ending on the date of sale, the home seller had to have:
1) Lived in the home as their main home for at least 2 years,
2) Owned the home for at least 2 years, and
3) In the 2 years prior to the sale, the home seller could not have used this tax benefit on the sale of any other home.
It's an amazing tax benefit, but if you decide to turn the home into a rental, be aware that this benefit could expire and it could happen overnight. In a housing market like we're in currently, where price appreciations are happening at breakneck speed, losing track of the expiration of your main home gain exclusion could potentially cause tens of thousands in federal and state income taxes that could have been easily avoided.
Purchasing a Rental Home
Buying a rental home can be a great way to build your wealth. A smart purchase could provide you with income as you operate the rental, and a big payoff when you sell. Here are some things to think about that could help you in managing the rental.
A rental property is usually reported on a form called Schedule E - Supplemental Income and Loss. In the section that reports expenses, one of the items is labeled "Depreciation". Depreciation is an expense that represents the theoretical reduction in value as you use an asset, and for many landlords, this is their single largest rental expense. I've seen a fair number of rental property owners (especially the ones who prepare their own tax returns) skip taking depreciation. Most of the times, it's because of the complexity. When trying to prepare their first tax return after purchasing the rental, their tax software will often try to gather information from the taxpayer, but the questions can sometimes be confusing so some just skip it, which causes depreciation to drop to zero.
If you are not experienced in tax preparation, it may help to visit a qualified tax professional to lead you through the proper reporting of your rental. This is especially true in the first year of your rental.
Also important, Hawaii has a number of taxes that may apply to your rental activities. General Excise Tax (GET) is a 4.5% tax on your "gross rental receipts". Depending on your gross rental income, you may be required to file periodic returns (G-45) on a semi-annual, quarterly, or even monthly basis. Don't forget to also file the annual reconciliation (G-49) before April 20 of the following year.
In addition to GET, short-term rentals (less than 180 consecutive days) are also subject to Transient Accommodations Tax (TAT) of 10.25% on the gross rental receipts. If you operate a rental subject to TAT, this tax is in addition to GET. TAT also has periodic returns as well as an annual reconciliation, just like GET. I helps to stay current on filings and payments, because penalties and interest could be very expensive.
Lastly, even if you are not a Hawaii resident, if you operate a rental in Hawaii, you will be required to file a Hawaii income tax return every year to report your rental activities. Even if your rental activities generate a loss, though you may not have to pay any income tax related to your rental activities, Hawaii will require you to file an annual income tax return nonetheless.
Admittedly, this is a very brief overview of a few of the tax issues that homeowners should consider. The world of real estate taxation is broad, so it may help to establish a relationship with a qualified tax professional who understands real estate tax issues, and can provide you with the proper guidance to make your home ownership experience as profitable as possible.