The Tax Cuts and Jobs Act (TCJA) - the purpose of which was ostensibly to make taxes more simple - has inspired a great deal of creative tax planning. Some planning, like bundling charitable gifts, may result in significant tax savings, while other techniques are doomed to fail. Unfortunately, the scenario pitched to your husband falls into the latter category. It’s not going to work. Here’s why.
Under the TCJA, the amount that you may claim on Schedule A for all state and local sales, income, and property taxes together may not exceed $10,000 (you can see what Schedule A might look like in 2018 here). Additionally, the TCJA caps new mortgages at $750,000 for purposes of the home mortgage interest deduction (for mortgages taken out before December 15, 2017, the limit remains $1,000,000). Those caps and limits, as you observed, do not apply to rental real estate (more on that here). That's led to some supposition that re-characterizing residential real estate might allow you to claim on a Schedule E what you can’t deduct on a Schedule A.
The Internal Revenue Service (IRS) doesn’t love what it calls form-over-substance techniques, and instead relies on substance-over-form principles. The substance-over-form principle can be boiled down to the adage, "If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck." In other words, you typically can’t repackage one thing (like residential real estate) as another thing (like rental real estate) and pretend it’s not the first thing to avoid paying taxes. So, from the start, I think that there’s a problem with the transaction as proposed because you’re not suggesting an alternative use, just an alternative skin.
But let’s assume for a moment that the IRS did allow the transaction. What then? If your husband did treat your home as a rental property and rented it to you, you could escape the Schedule A caps and limits by reporting expenses on a Schedule E. But in turn, you'd have to report the corresponding rental income. To keep it an arm’s length transaction, you’d have to charge fair market value rent. So if you paid $2,000 in rent to cover $2,000 in costs, it would be a wash since the income would offset the expenses. There’s no loss nor any benefit since you'd simply break even.
But, for the sake of seeing the idea through, let’s say that the IRS did allow the transaction and that there was a loss because the fair market value rent simply wasn’t enough to meet expenses. If you consistently produce a loss, you're bound to attract attention. The IRS has long considered profit motive as a critical factor to determine whether an enterprise is legitimate. In a real business, if you were consistently posting a significant loss, you’d either change gears or close down; you wouldn’t continue to plug along at the same speed, bleeding money. For your purpose, I assume you’d want to treat the real estate as a rental for at least the life of the TCJA provisions, or seven years. As a rule of thumb, when it comes to running a business, the IRS expects to see a profit at least three of five tax years. A consistent pattern of significant, unexplained losses will almost surely be disallowed on an audit.
(Note that other, more complicated rules may apply to the treatment of losses for self-rentals, but they’re a bit dense for our purposes. What you should know is that self-rentals tend to be subject to passive loss rules, and losses may not be deductible in the current year. The TCJA also adds a layer in the form of a new loss deduction rule. If you are engaged in a self-rental, even for legitimate purposes, you should check with your tax professional for more information.)
There are a few other issues to consider. By treating your home as rental real estate or transferring your home into a limited liability company (LLC), you may lose the benefit of the capital gains exclusion for your personal residence. The TCJA didn’t change those rules which allow you to exempt up to $250,000 of the gain from the sale of your home ($500,000 for married taxpayers). The capital gains exclusion is available to taxpayers who meet two tests:
- You must have owned your home for at least 24 months during the last five years leading up to the date of sale; and
- You must have lived in your home as your primary residence for at least 24 of the months you owned the home during the five years leading up to the date of sale.
If you don’t qualify for the exclusion, you must pay capital gains tax on any appreciation when you sell your home.
In addition, if you treat your home as a rental, you may lose other state and local residential tax breaks, like homestead and related deductions and rebates.
The LLC may further complicate matters. The LLC may be subject to additional taxes and fees since almost every state imposes some kind of initial filing and annual fees. In addition, you may be required to pay a real estate transfer tax or fee when you transfer the home into (or out of) an LLC or other entity; in some states, those fees can be substantial. Of course, in addition to state taxes, there may be rental registration fees and taxes imposed by your local government.
So even if you could figure out how to make the transaction work on paper, any federal income tax savings could easily be eaten up in state and local taxes and fees.
Finally, don’t forget the non-tax consequences of treating your home as a rental. If your home is subject to a mortgage, your lender may balk at a transfer or require you to take out a more expensive commercial mortgage (those typically require a higher down payment). You may have to switch out your homeowner's insurance for a commercial or rental policy. You may be required to hardwire the property to meet local police and fire alarm related ordinances. More important, your local zoning and other laws may not even permit a rental in your neighborhood.
The bottom line: Nobody wants to pay more in taxes than they have to, but be careful. Make sure that you consider all of the possible consequences - taxes and otherwise - before making significant changes. As with the question of whether to incorporate (you can read more on that here), it’s essential that you do your homework. Figure all of the costs and consequences before transferring your home (or other assets) to save taxes. And remember: Every taxpayer is different. If you have questions, you should consult with your tax professional.