The IRS has four different types of real estate. Each type of property has benefits based on its classification. The property itself does not determine the classification as much as how the property will be used and the intentions of the owner. Below are some classifications and their definitions.
Principal Residence – this would be the place where you live or the place where you return to after being away temporarily. It can be a single-family dwelling, a detached home, a condominium, a duplex, a tri-plex or a four-unit home. The owner(s) can deduct the qualifying mortgage interest and property taxes on a Schedule A tax return form. Capital gains exclusion exist on the profit of up to $250,000 for a single taxpayer and up to $500,000 for married filing jointly.
Income Property – renovated or improved property that is leased or rented to tenants and is not used personally by the owner(s). Income property can be houses, condos, apartment buildings, office complexes, shopping centers, warehouses or other commercial buildings. You may take depreciation on the improvements. If the property is held for over a year, the profits are taxed at long-term capital gains rates. This type of property is eligible for a tax-deferred exchange.
Investment Property – this can be vacant land or an improved property that is not leased or rented. It is not subject to depreciation. The sale profits are taxed at the long-term capital gains rate if the property is held for over a year. It is eligible for a tax-deferred exchange.
Dealer Property – this type of property is primarily considered inventory because the intention is to sell it without intentionally holding it for more than a year. It could be new construction such as a home builder. It could be an investor who buys a property and expects to sell it for more. There is not a requirement to make improvements. The profits on dealer property are taxed as ordinary, “sweat of the brow” income. Dealer properties cannot be exchanged.
Second Home – like a principal residence in that you can deduct the interest and property taxes on your Schedule A, up to the limits. A second home, as well as a principal residence, can be rented out up to 14-days a year without threatening the status of the property. Seconds homes are not eligible for exchange because personal use properties are not allowed. A second home is not a principal residence and profits are taxed like an investment property. If you own it for more than a year, it is taxed at long-term capital gains rates.
Vacation Homes – rented for more than 14 days a year and are like income property but with some additional rules that apply. If your personal use is 14 days or less or 10% of the time it is rented, your expenses can be deducted in excess of income. If you use it for more than 14 days or more than 10% of the number of days it is rented, it is considered personal use and your expenses are limited to the amount of income collected with no losses being deductible.
Based on their intentions, taxpayers can strategically change the property type. A principal residence can be converted to income property or a dealer property could become a principal residence. A rental property could also become a principal residence.
I always suggest you seek professional tax advice to help you understand the information above and how it applies to your specific situation.
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