Real Estate NewsThis May Be A Difficult Year To Determine Your Tax Obligations
President Bush has proposed -- once again -- major tax reforms. And with a friendly Congress, it appears likely that some form of tax legislation will be enacted early this year. Indeed, there is even talk of making some of the tax laws retroactive, which will make it even more difficult for most taxpayers to prepare and file their income tax return.
Nevertheless, unless you opt to take the four month automatic extension by filing application form 4868, all personal income tax returns must be filed no later than Tuesday, April 15th of this year. And keep in mind that even if you obtain the extension, you still have to pay the tax you owe by the April 15th date. If payment is not made, interest will accrue.
For years, there have been voices calling for tax reform -- in and out of the halls of Congress. One measure which is always proposed -- but never enacted -- is to repeal the favorable interest deductions that those of us who have mortgages can take.
But until we see any tax reforms, we have to meet the tax deadlines. There are a number of tax benefits available for most American homeowners, but you have to understand them and report them properly to the IRS.
This series of articles is designed to assist the homeowner in understanding the real estate tax laws – both residential and investment – so that you can take advantage of each and every tax benefit. Keep in mind that if you are in a 35 percent Federal tax bracket, for example, for every additional dollar you can legally deduct, you will be saving 35 cents that does not have to go to Uncle Sam.
Our tax laws are complex, and there are a number of definitions and concepts which must be understood:
Basis -- this is the initial cost of the property, plus any improvements you have made over the years.
Gross profit -- the difference between what you originally paid for your house and the sales price.
Net profit -- you have to subtract any improvements you have made to the property, and also any real estate commissions paid when you sold the property. The bottom line net profit is also called "capital gain."
Homeownership is still the Great American dream, and continues to be endorsed, encouraged and supported by our Federal Tax Code. Consider this typical scenario: in 1972, you bought your first home for $35,000. You and your spouse had two children, and your first home was just too small. You sold your home for $65,000, and bought another for $90,000.
Your profit -- not taking into consideration expenses, improvements, or real estate commissions -- was $30,000. But since you were then able to take advantage of a tax benefit known as the "rollover," you did not have to pay tax on these capital gains. The rollover was completely eliminated when President Clinton signed into law the Taxpayer Relief Act of 1997. Homeowners are now permitted to exclude up to $250,000 of profits made on their principal residence ($500,000 for married taxpayers filing joint returns). And this exclusion is not limited to any one sale, but can be taken every two years – so long as you meet certain eligibility criteria. (The next column will explore the new IRS Regulations, issued December 23, 2002, relating to excluding gain when you sell your home.)
Congress also repealed the "once in a lifetime" exemption, whereby homeowners over the age of 55 were given a one-time absolute exclusion of up to $125,000 of the overall profit made on the sale of their principal residence.
Thus, the "rollover" and the "once in a lifetime" exclusion are history, having been replaced by a more simplistic – and more financially rewarding formula: up to $500,000 of profit can be excluded every two years.
For those of us who own homes, and are preparing to file our 2002 tax returns, here is a list of the itemized tax deductions available to most homeowners::
Mortgage Interest Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married, but file separately, the limits are split in half.
The concept of an acquisition loan is very important, and has confused – and even trapped – a large number of homeowners. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home. However, any other excess may qualify as a home equity loan. Both the IRS and this columnist do not support loans which exceed the total equity in your house. Your house is perhaps your most valuable asset, and obtaining a loan which is greater than the value of your house is too dangerous a risk to take.
Let us look at this example: Several years ago, you purchased your house for $200,000 and obtained a mortgage (or deed of trust) in the amount of $160,000. Last year, your mortgage indebtedness had been reduced to $150,000, but because the market dramatically increased, your house is now worth $300,000.
Because you wanted to pull out some cash from the equity in your home, you refinanced and were able to get a new mortgage of $240,000. For tax purposes, your acquisition indebtedness is $150,000 (i.e. the amount of your existing loan). The additional $90,000 that you took out of your equity ($240,000 - $150,000) does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan. Accordingly, the entire mortgage interest which you pay on this new loan will be fully deductible. It should be noted, however, that if you are in a high tax bracket, you may not be able to take all of these deductions, and you must consult with your tax advisors on this matter.
The Internal Revenue Service has made it clear that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you would have borrowed $260,000, you are only able to deduct interest on $250,000 of your loan -- the $150,000 acquisition indebtedness, plus the $100,000 home equity.
The remaining interest is treated as personal interest, and unfortunately is not deductible. If, on the other hand, you borrowed this additional money for the purpose of making improvements to your property, that would increase your “acquisition indebtedness” and the entire amount of the interest will be deductible.
You should also note that for all practical purposes, there are no restrictions on the use of the money obtained from a home equity loan. You no longer have to justify your loan as meeting certain educational or medical requirements.
Taxes Property taxes, both state and local, can be deducted. However, real estate taxes are only deductible in the year they are actually paid to the government. Thus, if last year you escrowed monies with your lender for taxes to be paid in 2003, you cannot take a deduction for these taxes when you file your 2002 return.
However, if you bought a house last year, you may have reimbursed your seller for a portion of the prepaid taxes through the end of 2002. Review your settlement sheet carefully. Line 106 on page 1 of that statement should reflect this tax adjustment. Since this was a current payment by you for real estate taxes, it is a deductible item. Indeed, when you receive your annual statement from your lender showing the amount of taxes paid last year, it will not be included in that statement. Lenders are required to send these annual statements to borrowers by the end of January of each year, reflecting interest and taxes paid for the previous year. Since your lender did not pay these tax adjustments, they will not report them to the IRS.
Points When you obtain a mortgage loan, you often have to pay one or more points to get that loan. Whether referred to as "loan origination fees," "premium charges," or "discounts," they are still points. Each point is one percent of the amount borrowed; if you obtain a loan of $250,000, each point will cost you $2,500.00. (A column later in this series will discuss the tax treatment of points).
Next Week: The New IRS Regulations on Selling your House