Let Uncle Sam help fund a retirement home

By Jeff Schnepper

How'd you like to buy your retirement home now, financed with IRS dollars? And while you're building up this nest egg, how'd you like to take legitimate allowable tax deductions for the cost . . . and never pay tax on any appreciation?

Sounds almost too good to be true. But it's quite legal. Indeed, the tax code practically encourages people to take advantage of the rules.

Congress has always loved real estate. Or, at least our representatives have been very receptive to the persuasive arguments of the real estate lobby. In any case, the Internal Revenue Code is replete with provisions favorable to those who invest in real estate.

The beauty of 1031 tax-free exchanges

One of these provisions in the IRS Code, Section 1031, provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like-kind property.

There are lots of exceptions and limitations, but, for our purposes, all you need to know is that all investment real estate qualifies under this provision.

So,the bottom line for you is become a landlord. Buy a piece of rental property and rent it. Work either with a real estate broker or do it yourself with an ad in the paper. And then build up the investment until, finally, you end up with your dream home.

(I admit being a landlord takes some work and time, and you may not be up for the effort. Moreover, if you're close to retirement age, this strategy may not work for you because it requires some years to accomplish.)

I believe you should always buy a property you can watch. One of my New Jersey clients bought a house on the Outer Banks of North Carolina as a vacation rental. He couldn't understand why it was renting so poorly during high season until he made an unannounced visit and found his broker spending the summer living there. Happy ending: While he didn't get the rental income he had hoped for, the property sold for three times what he'd paid for it, and he had it for only two years.

Because this is rental property, you get to deduct all the expenses related to running the property. These include taxes, interest, insurance, repairs, utilities, supplies, cleaning, maintenance and any commissions you pay (to leasing agents and the like). You can also deduct any mileage you incur going to keep an eye on the property. For 2009, the rate is 55 cents a mile for business use.

Big bucks from depreciation

Hopefully, these out-of-pocket costs are offset by the rental income the property generates. But here's where the big bucks come from:

You get to depreciate the cost of the property. You depreciate the building, not the land. Apply the percentage allocation on your real estate tax bill between land and improvements to find your depreciable basis. If 85% of the assessment is for improvements, 85% of your total cost for the property, including any capitalized closing costs (e.g. title insurance, legal fees etc.) is allowed as a deduction, spread over 27.5 years for residential rental.

Remember, this depreciation expense allowed on your tax return (Schedule E) is based on the total cost, not what you put down. If you buy a $120,000 rental property and put down 20% ($24,000), your depreciation is based on the whole cost -- $120,000. If 85% of your property-tax bill is allocated to improvements, assuming $2,000 in closing costs, your yearly deduction for depreciation is $3,771 (Add $120,000 and $2,000, multiply the sum by 0.85 and that result by .03636.) If you're in the 28% bracket, you save $1,056 in taxes. In the 25% bracket, the savings come to $943.

Remember, this depreciation expense is a pencil transaction. While you're taking a tax deduction for the "depreciation" of your property, it may actually be appreciating in value! (At least, that's our hope.)

Continued: Buy, reinvest, repeat

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