Property ownership offers many
benefits — including tax savings

Although the real estate market has its ups and downs, real estate can be a valuable investment — whether it's your home or vacation home or a rental or investment property. (For information on some temporary breaks for owners of leasehold, restaurant or retail properties, see “What’s new! Depreciation-related breaks extended and expanded.”) Property ownership also can offer significant tax savings, as long as you take advantage of all the breaks available to you. But watch out for the limitations as well.

Home-related tax breaks

Whether you own one home or several, it's important to make the most of available tax breaks:

Property tax deduction. If you're looking to accelerate or defer deductions (see "Timing income and expenses"), property tax is one expense you may be able to time. You can choose to pay your bill for this year that's due early next year by Dec. 31, and deduct it this year. Or you can wait until the due date and deduct it next year.

Mortgage interest deduction. You generally can deduct (for both regular tax and AMT purposes) interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.

Home equity debt interest deduction. Interest on home equity debt used to improve your principal residence — and interest on home equity debt used for any purpose (debt limit of $100,000) — may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn't deductible.

Home-office deduction. Many rules apply. (See the Case Study "Home office deduction can save you tax — if you're eligible" for details.)

Debt forgiveness exclusion. Homeowners who receive debt forgiveness in a foreclosure or a mortgage workout for a principal residence generally don’t have to pay federal income taxes on that forgiveness.

Energy-related breaks. A wide variety of breaks designed to encourage energy efficiency and conservation are available. Consult your tax advisor for details.

Home rental rules

If you rent out all or a portion of your principal residence or second home for less than 15 days, you don't have to report the income. But expenses associated with the rental won’t be deductible.

If you rent out your principal residence or second home for 15 days or more, you'll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation. Exactly what you can deduct depends on whether the home is classified as rental property for tax purposes (based on the amount of personal vs. rental use):

Nonrental property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an itemized deduction for the personal portion of both mortgage interest and property taxes.

Rental property. You can deduct rental expenses, including losses, subject to the passive activity rules. (See "Passive losses.") You can't deduct any interest that's attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property.

Home sales

When you sell your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain if you meet certain tests. To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by casualty losses and any depreciation that you may have claimed based on business use.

Warning: Gain on the sale of a principal residence generally isn't excluded from income if the gain is allocable to a period of nonqualified use. Generally, this is any period after 2008 during which the property isn't used as your principal residence. There's an exception if the home is first used as a principal residence and then converted to nonqualified use.

Losses on a principal residence aren't deductible. But if part of your home is rented or used exclusively for your business, the loss attributable to that portion will be deductible, subject to various limitations.

Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It will be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange.

Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.

Real estate activity losses

Losses from investment real estate or rental property are passive by definition — unless you're a real estate professional. Then you can deduct real estate activity losses in full. To qualify as a real estate professional, you must annually perform:

• More than 50% of your personal services in real property trades or businesses in which you materially participate, and
• More than 750 hours of service in these businesses during the year.

Each year stands on its own, and there are other nuances to be aware of. If you're concerned you'll fail either test and be stuck with passive losses, consider increasing your hours so you'll meet the test. (See "Passive losses" for more on the rules.)

Tax-deferral strategies for investment property

It's possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may, however, be risky from a tax perspective until there's more certainty about future capital gains rates — if rates go up, tax deferral could be costly. (See the Chart “What's the maximum capital gains tax rate?”) So tread carefully if you're considering a deferral strategy such as the following:

Installment sale. An installment sale allows you to defer gains by spreading them over several years as you receive the proceeds. Warning: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received.

Sec. 1031 exchange. Also known as a "like-kind" exchange, this technique allows you to exchange one real estate investment property for another and defer paying tax on any gain until you sell the replacement property. Warning: Restrictions and significant risks apply.