What are Examples of Tax Loopholes

What is a loophole? Investopedia defines a loophole as “a technicality that allows a person or business to avoid the scope of a law or restriction without directly violating the law.” There are several loopholes that are in the U.S. Tax Code. Below are a few of Tax Loopholes that you can use for your taxes.

Loophole for Primary Residence Exclusion Test

The Property Selling section detailed how you can exclude up to $250,000 of gain on the sale of your principal residence if you are single, or up to $500,000 if you are married. You may ask “can I use the primary residence exclusion as a tax shield for gains on real estate other than my primary home?” The answer is YES. If you own a rental property or a vacation home you can qualify for this exclusion if you move out of your primary residence and into your vacation or rental property, live there for two years, then sell the former vacation home or rental property. If you are willing to make the sacrifice to move into your vacation home or rental property for the 2 year minimum requirement, the tax reward could prove to be quite large. The steps are simple and as follows:

      1. Move out of your primary residence and either sell it or rent it out.
      2. Move into your vacation home or your rental property and make it your principal residence. Your move must be legitimate. An example of proving legitimacy would be to switch your voter registration to your new address.
      3. Sell your principal residence, which used to be your vacation home or rental property tax free. Note that you must meet the standard requirements for the primary residence exclusion.

NOTE: Some of the gain on a sale after 2008 might not be excludable, even if the two-out-of-five year ownership and use tests are met, if your use the residence after 2008 as a second home or rental property.

To learn about Primary Residence No Exclusion for Non Qualified use, click here.

Getting Money From a 1031 Exchange via Loophole

As noted in the Property Selling section of this site, any money you receive while using a section 1031 like-kind exchange is considered “boot”. Boot is fully taxable and is added to your income. When you do a 1031 exchange for like-kind property, you are required to roll over all cash you might receive in the sale. You may think to yourself, “Why not take a loan out on my existing property prior to doing the like-kind exchange?” The answer is that you can’t.

The rules of Internal Revenue Code 1031 say that you cannot do that. What you can do is take out a loan on the property you received in the like-kind exchange. Thus, you would do the following to get cash from the 1031 exchange; (1)do the 1031 exchange for like-kind property, (2) receive the new property, and (3) refinance. This loophole allows you to receive cash without jeopardizing the 1031 transaction.

Using an IRA to Purchase Real Estate via Loophole

One of the lesser knows caveats to real estate investing is that you can structure your individual retirement account (IRA) so that you can purchase real estate through your IRA. Depending on the type of IRA, the rental income you receive and the capital gains on those investments will be either tax deferred, or in the case of a Roth IRA, completely TAX FREE. This isn’t really a “loophole” per se, just a relatively lesser known method to acquire real estate.

You may also withdraw up to $10,000 from your IRA to help with the down payment on your new home without having to pay the 10% IRS penalty for withdrawing money from your IRA before the age of 59 1/2.

Learn about real estate investing using an IRA here

Charitable Contribution Deduction Loophole

As the end of the year approaches, the IRS reminds taxpayers that they may be able to use their gifts to tax-exempt charitable and religious groups to reduce their taxes.

Charitable contributions are deductible only if you itemize your tax deductions.

For a comprehensive overview of charitable tax deductions, click here.