Preserving Equity and Reducing Tax Obligations
In the first quarter of 2022, the collective amount of equity money that homeowners with mortgages on their properties could convert to cash while still retaining 20% or more equity increased by a whopping $1.2 trillion, according to Black Knight.
Between April 2021 and April 2022, mortgage holders’ “tappable equity” increased by 34%. Tappable equity is described as the difference between the existing mortgage debt and the estimated current value up to 80% loan-to-value (LTV).
Nationally, homeowners’ tappable equity also reached an all-time record high of $11 trillion dollars in the same April 2022 time period. This $11 trillion dollar figure was two times as large as the previous peak high back in 2006. The average tappable equity amount available for homeowners averaged close to $207,000.
Property owners’ net gains are most important after paying closing expenses and taxes, if applicable. The lower the amount of taxes paid, the higher that the net worth will compound and grow over time as you will soon learn.
Access to Liquid Funds
A high percentage of homeowners and rental property investors have significant wealth that’s primarily derived from their real estate assets.
Yet, the property owners may have very little cash holdings available for basic monthly expenses like food, gas, clothing, and travel. It’s not like a property owner can use their deed of trust or promissory note at the grocery store to fill their cart up with food as if it were a credit card.
The average homeowner across the nation who retires has upwards of 83% of their net worth tied up in equity in their primary home. If so, they only have about 17% of their available net worth as liquid or fairly liquid funds found in checking, savings, or retirement accounts which may still have some early tax withdrawal penalties depending upon their age.
Record High Tax Collections
One of the main reasons why homeowners and rental property investors are hesitant to sell their properties is due to potential tax bills that could significantly reduce their net gains.
Through the end of the 3rd quarter in 2022, the federal government spent $6.27 trillion while only collecting $4.90 in income revenue from sources like tax payments from individuals and businesses. This meant that the government had a budget deficit of $1.38 trillion.
To offset the federal deficit spending, Congress and other lawmakers have actively tried to reduce taxpayer deduction allowances as a way to increase taxes collected to create a more balanced budget. For example, the $4.90 trillion in federal taxes collected in 2022 was an all-time record high amount. This figure was $850 billion higher than the $4.05 trillion collected in 2021.
The Baby Boomer generation members (born between 1949 and 1964) who control the highest percentage of real estate assets also have to protect their assets from tax penalties related to home sales while living and potential future “death taxes” that may penalize their designated heirs. Approximately 10,000 Baby Boomers per day reach the age of 65 across the US. By 2030, all Baby Boomers will be at least 65 years of age.
Tax Planning and Real Estate Investments
We here at Sterling Investor Group do our best to share the most creative and effective ways to reduce tax obligations from the sale of both owner-occupied and non-owner occupied property investments.
Next, we’ll take a look at how you may be able to utilize both the benefits of the IRC Section 121 and IRC Section 1031 to eliminate and/or defer tax obligations from your equity gains.
For our owner-occupant clients who sell their homes after living there at least two years or 24 months, they may exclude or avoid paying any capital gains tax up to $500,000 for married couples who file jointly or up to $250,000 for an unmarried individual owner. Property owners who buy and sell their real estate holdings that are held less than one year or 12 months may pay a tax gain that’s applicable to an ordinary income tax anywhere between 10% and 37%, depending upon their income tax bracket.
For our investor clients, they can delay the capital gains received from the sale of one or more investment properties for so long as they identify a new property or properties to acquire within 45 days and close escrow within six months under the 1031 tax-deferred exchange program.
In 2005, the IRS drafted the Revenue Procedure 2005-14 tax guidelines as a way for taxpayers to use both benefits from the IRC Section 121 and IRC Section 1031 tax codes for the exact same property or properties within a minimum 5-year window.
How is it possible that the exact same property can be designated as owner-occupied and non-owner occupied for tax benefit purposes? The simplest explanations are as follows:
- The property owner lives in the residence for a total of at least two of the five years when seeking capital gains avoidance up to $250,000 for individuals or up to $500,000 tax exclusions for married couples who file jointly under the owner-occupied IRC Section 121. The same property owner had rented out the same property for a few years prior.
- An owner-occupied property is later converted to a rental property after the property owner moves elsewhere and leases the same home. Later, the property owner will seek the benefits of tax-deferred gains by utilizing the 1031 tax-deferred exchange approach.
Compounding Home Value Gains Statewide
The average home sales price in King County reached $1,078,000 for January 2022, as per Zillow.
While home prices are generally significantly higher in King County than across the state, let’s take a closer look at the median home price statewide dating back to 2001:
|YEAR||Statewide Median Home Price|
Over the past 21 years, you could have exchanged a rental property and later converted it to an owner-occupied residence for a period of just two years prior to taking the gains tax-free up to $500,000 per married couple. Or, you could’ve converted an owner-occupied residence to a rental property at a later date. In theory, a property owner might have been able to legally do this upwards of several times over the same 21-year time period.
Please consult your personal tax advisor and accountant before making any investment decision. Tax codes can change rather quickly, so you must be absolutely certain that you’re following the latest tax and investment guidelines.
Our team at Sterling Investor Group will continue to keep a close eye on any future tax and investment code changes that may provide even more future opportunities for our clients.