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Congress also repealed the "once in a lifetime" exemption, whereby homeowners over the age of 55 were given a one-time absolute exclusion of up to $125,000 of the overall profit made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Thus, the "rollover" and the "once in a lifetime" exclusion are history, having been replaced by a more simplistic – and more financially rewarding formula: up to $500,000 of profit can be excluded every two years.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::

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.

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.

Next Week: The New IRS Regulations on Selling your House