Step Six – Buy a House!
Creating All the Money You Will Ever Want
By Diane Kennedy CPA/Tax Strategist
Q. When is an asset also a liability?
A. When it is your home.
Most people consider their home to be an asset, because its value increases as the local housing market rises. Yet, if we define an asset as something that puts money in your pocket and a liability as something that takes money from your pocket, your home actually qualifies as a liability. That's because most people fail to take advantage of the HomeLoopholes™ that are available for their personal residences.
Secrets of the Rich
In previous modules, we have covered the Seven Proven Steps that the rich use to make and grow their money. In the first module, we covered an overview of the system and debuted the seven steps:
- Create a Business.
- Discover Your Hidden Business Deductions.
- Pay Your Taxes.
- What's Left Goes Into Real Estate.
- Real Estate Income Comes Out Tax-Free.
- Buy a House the Right Way.
- Make Your House Give You Money.
Last month we discussed Step 5 – how to take money out from your real estate investments. Once you've done that, it's time to buy your home!
Did you notice that we put the purchase of your home after you've begun a business and after you've invested in real estate? You don't necessarily need to do it in that order, especially if you take advantage of the HomeLoopholes™ that turn your home into an asset. But, it is our belief at DKA that you should avoid the typical American idea of buying a big house with no other investments. That's when your house really becomes a liability. Also, be wary of advice to buy a bigger house as you make more money, because the mortgage interest and property tax deductions phase out as your income increases. (That's why the typical tax strategy ceases to work as your income increases).
How Much House to Buy
How much house should you buy is obviously a very personal question. Mortgage companies typically don't want to see you spend more than one-third of your income in a mortgage payment, and that's a good rule of thumb. Personally, I think the order you buy your home (after your business and your investments) is just as important as how much of a house you buy.
Buy the Right Property
Don't buy any property, just to buy a property. Some of the items to look for are:
- Lower priced home in a higher priced neighborhood
- Minor fix-ups required (cosmetic items such as paint, carpet, and the like)
- Neighborhood is up and coming
- City with historically higher than average appreciation
What's Your Exit Strategy?
Before you buy your home, determine your exit strategy and establish your plan. You might decide to buy homes that you remodel and live in for two years before selling, taking advantage of the $250,000 tax-free gain exclusion available for single taxpayers. Or, you might keep the home and convert it into a rental when you move into another property.
Record-keeping Requirements
To take advantage of the HomeLoopholes™ that turn your home from a liability into an asset you will need to keep a set of permanent and temporary financial files for your home. The permanent files will have all the documentation related to the basis of your property, including:
- Closing statements from the purchase of your home (called a HUD-1).
- "Rollover" basis from a previous sale and purchase. If your previous home was sold pre-1997 and the basis was rolled into your current home you will need to know this rolled over-amount for calculation upon a sale.
- Receipts and contracts related to additions and improvements.
- Any documentation related to a partial sale of your property.
- Copies of insurance policies, property tax information and any other pertinent information regarding your home.
The temporary files will be used to keep your records to back up your yearly depreciation deduction – i.e., your mortgage interest and property tax deduction. Your mortgage company will report these to you on a Form 1098 at year-end. Don't forget to include all of the loans you have on your property, such as equity credit lines.
Believe it or not, the single biggest mistake Americans make when filing their taxes is failing to properly itemize their principal residence expenses of mortgage interest and property taxes. The General Accounting Office released a frightening statistic in 2002 – Americans overpaid their taxes by approximately half a billion dollars per year. Don't make this mistake! Make your home work for you, not against you!
Three Strategies to Protect Your Home
While looking for your new home, consider how you will protect it. There are three basic strategies to protect the equity in your home: (1) Homestead Exemption, (2) Limited Liability Company, and (3) Equity Stripping. These are each covered below.
Homestead Exemption
A homestead exemption protects a portion of your home against judgments. For example, if you have a homestead exemption of $100,000 allowed in your home state and your equity (difference between the fair market value and the mortgage balance) is less than $100,000, your home is all protected. Or, if you had equity in the amount of $150,000, your house could be sold without your permission but you would still get the $100,000 covered by your homestead exemption back.
The amount of the homestead exemption is determined by each state's statute. Check with your local government property tax assessment office to determine what paperwork is necessary to file for the homestead exemption in your area. Some states have automatic homestead exemption. Don't assume that your state does!
Limited Liability Company (LLC)
In many states, the single-member LLC has asset protection by state statute. Be sure to check with an attorney in your area for the latest news on your local LLC. But, in states where the single member LLC is a protected structure, the IRS now allows you to hold your principal residence within a single member LLC and still have all of the tax benefits of private, personal ownership.
Equity Stripping
The old tried and true method of equity stripping might be the best alternative for residents of states with uncertain LLC laws and low homestead exemption amounts. Equity stripping is a method of refinancing property to pull out of the equity. You can then use the money to invest (using, of course, proper asset-protection business structures to protect the money). Your equity has been "stripped" out and you are less of a target.
The next Module (Step Seven) will demonstrate some more innovative HomeLoopholes™ that you can use to take the best advantage of your principal residence.
Diane Kennedy is a CPA/Tax Strategist and the author of the best-selling book Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax and co-author of the best-selling book
Real Estate Loopholes: Secrets of Successful Real Estate Investing. For more information on how to legally use the tax loopholes and make the IRS your partner, contact Diane's CPA firm, DKA, at 888-592-4769 or www.dkacpa.com. Tax law is constantly changing! Keep up to date for free by signing up for a free e-newsletter at www.taxloopholes.com