LET THE IRS PAY FOR YOUR NEW HOME Another strategy to consider when you purchase or sell a home is how you can take advantage of the deductibility of home mortgage interest. This is one case where debt can be useful. But, briefly, the trick is to mortgage your property (especially at low interest rates) and then put the money into tax-free investments. Thus, if you mortgage the property at 6%...and put the money into tax-free investments yielding 6%...it looks like a wash. But you actually end up ahead. Say the amount is $100. Your mortgage costs you $6, which you deduct from your taxes. At a 40% tax rate, the real cost of the $6 payment is only $3.60. That is, it reduces your taxable income by $6...thereby sparing you $2.40 in taxes. Plus, you get another $6 in tax-free interest. Using this technique, you'll end up with $8.40 in tax-free earnings...or 8.4% tax free, instead of only 6%. In other words, you increased your tax-free earnings by 40% with no increase in risk. If you sell a home for a $100,000 gain, and buy another one at the same price, using this trick you'll put $200 in your pocket, tax free, each month! While your home can, in a sense, be free to you because of its long-term wealth-generating potential, it can also be free for all the years you live in it -- as you continue to build wealth. The key is to make your home a deductible expense. If moving away is just not possible for you right now, set up a business within your home. You can deduct some of your home expenses through the business. If you buy a personal residence for $300,000 and are taxed at a 40% rate -- which many, if not most, people are -- you would have to earn at least $500,000 to pay for it. And that doesn't include a penny of interest on the mortgage (which is deductible). No matter how much you pay, your investment is worth whatever the property is worth -- which, as we have seen, might be a lot less than you anticipated. But suppose you could make the purchase a deductible expense? In some special situations, you can. If a business purchases a property for $300,000, and depreciates the expense over the mortgage period, the cost to the company would be only $300,000 rather than $500,000 -- a $200,000 savings. Remember, though, land is not depreciable -- to anyone. Similarly, investment property may be depreciated (deducted over a period of years). Here again, the real cost of acquisition is greatly reduced. The trick then is to turn residential property into business or investment property, thus allowing you to deduct the cost of acquisition and thereby save enough money to give you a new home free. You cannot depreciate your primary residence. By definition, the place you live is a personal expense, not a business or investment expense. But if you buy another home, for investment purposes, you would be able to deduct the expenses, including the depreciation. Likewise, if you have a business of your own (this is just one of the many instances in which having a business can pay off), and the business needs a place to operate from, you can -- in certain cases -- have the business buy a property and deduct the expenses. In this case, the business would buy a place from which to conduct business. And you would rent from the business a portion of the property as a living space. This is the opposite of the typical "office in the home" situation...from a tax perspective. At the same time, it is precisely the same arrangement. But in this case, the property is business property, and as such, fully deductible. You just have to pay fair market rent for the part of the place you occupy. The value of the portion you occupy will be significantly depressed by the fact that you share the residence with a business. You can imagine how much less it would be worth to you if you had to share with such a business and adjust the rent accordingly. The rent is not, of course, a business expense. It is a personal living expense and cannot be deducted. Still, the savings may be significant. Your incorporated business buys a house (watch out for zoning and other regulatory problems) from which to conduct business. It pays $200,000 and deducts both the interest and the principal (as depreciation) over the life of the mortgage. Thus the total cost of acquisition is $200,000...before tax dollars. The house would rent for $1,500 a month. But since you have to share the property with a business...a fair market rent may be just $750, maybe even including utilities. Meanwhile, the business gets to deduct the maintenance, utilities, and other costs of operation. The only taxable amounts involved are the monthly payments you make to the business in rent. And you have to watch out that you don't end up getting these amounts taxed twice, or even three times...by ending up with a profit in the company, which is taxed at the corporate rate, and then paying it out to you again ... where it is taxed at your personal rate. You have to pay attention, in other words, to the details in a transaction like this. How much can this arrangement save you? Let's say the mortgage payments are $2,000 per month for 20 years. You can only depreciate the improvements, not the lot, of course, but let's not make this example too complicated by assuming that the lot has minimal value. So you get to deduct the entire $200,000 purchase price over the 20-year period. (Be sure to check allowable depreciation schedules.) Plus, let's say upkeep and utilities average $200 per month...all deductible as well, for a deduction of another $48,000. This brings a total deductible amount of $248,000... which is a savings of $99,200 in taxes. But, remember that we still have to pay the tax on the rent we pay. Alas, that amount works out to $72,000. So the net effect is a savings of a little more than $27,000. However, the savings do not occur all at once. They're spread out over 20 years. Thus, the magic of compounding comes into play. Each year, you save about $1,350. With compounding at 10%...at the end of 20 years, you'd have $55,806. Here's another variation: Your corporation can lease your land from you and build a house on it. You rent the house until it reverts to you at the expiration of the lease. The house can be in Hawaii...or the Upper East Side of New York City. The corporation depreciates the cost of construction and deducts the cost of maintaining the house. The corporation's lease payments to you for the use of the land are deductible to the corporation. Your rental payments for the use of the house are income to the corporation. When the land lease ends, say after 20 years, the land and building are both yours. You need not recognize any income as a result of the improvements the corporation made to your land. Your basis in the house will be zero, because you recognized no income. If you sell the house, all proceeds will be long term capital gains. If you occupy the house as your residence and are qualified (over age 55, file a joint return with your spouse, and have lived in the house for three out of five years), you can take advantage of the one-time $125,000 exclusion. On the other hand, if you leave the property to your heirs, the value to them will be the fair market value at the time of your death, and the capital gains will never be taxed. Now, having said all that, we hasten to add that any time you start to fool around with IRS regulations you run into problems. Basically, the IRS has the job of collecting money from people. And though it is well established that you have the right to organize your affairs in any way you please in an attempt to lower your tax liability, the IRS and Congress are determined to try to prevent you from exercising that right. We'll have a lot more to say about taxes in this book. Because they are by far the biggest single item in most family budgets. As such, they are also the most fertile field for growing your personal wealth by reducing the amount of taxes you pay. But for now, let us just point out that you need expert advice to set up a tax-avoiding structure such as the one we are explaining here. The specific form of the structure will depend on your own personal situation and your goals.