Housing Counsel: Income Tax 101

Written by Posted On Sunday, 15 January 2006 16:00

On November 1, 2005, the President's Advisory Panel on Federal Tax Reform issued its final report. The Panel proposed a number of tax reforms, many of which can directly impact on real estate investors and homeowners alike.

The most significant recommendation was that the deduction for mortgage interest be replaced with a Home Credit which would be available to all homeowners. This Home Credit would be equal to 15 percent of the mortgage interest paid by a taxpayer on a loan which was secured by the taxpayer's principal residence, and used to acquire, construct, or substantially improve that residence. The Panel also recommended that the deduction for mortgage interest on second homes and on home-equity loans be eliminated.

According to the Panel's final report:

The Home Credit would encourage home ownership, not big homes. More Americans would be able to take advantage of tax benefits for owning a home, while the current subsidy for luxury and vacation homes would be curtailed. In addition, the Home Credit would reduce the incentive to take on more debt by eliminating the deduction for interest on home equity loans.

Recognizing that such limitations could adversely affect individuals who purchased or refinanced homes on the assumption that they would be able to deduct interest on up to $1.1 million of mortgage debt (which is current law), the Panel further suggested that there be a gradual phase-in of the cap over a five-year period for pre-existing home mortgages.

Will any of the Panel's recommended reforms be enacted by Congress this year? Perhaps some will become law, but the great majority of the proposals will be stalled by lobbyists, the Congressional elections coming up in November, and other priorities such as aiding Katrina victims, Iraq and of course the legal and political battles in which the White House is currently fighting.

What is certain, however, is that tax time is once again here. This year, April 15th falls on a Saturday, and thus all income tax returns must be postmarked by midnight, Monday, April 17. However, the Internal Revenue Service has given taxpayers a new break this year. Instead of the four month automatic extension, you can now opt for a six month automatic extension by filing application form 4868.

According to an IRS press release:

The new regulations provide streamlined and simplified procedures that are expected to save taxpayers between $73 million and $94 million, annually, by eliminating or consolidating several existing IRS forms. As a result, beginning Jan. 1, 2006, most individuals and businesses will be able to request a full six- month tax-filing extension, without a reason or even a signature.

The new procedures will replace the existing two-step process under which noncorporate taxpayers could only get a six-month extension by first obtaining an extension, usually automatic, for part of that period and then requesting a discretionary extension for the remainder. A tax-filing extension does not extend the tax-payment deadline.

The last sentence is extremely important. It must be understood that even if you get an extension to file your tax return until October 15, you must still pay the tax you owe by the original due date -- April 17th.

There are a number of tax advantages available for most American homeowners, but you have to understand them and report them properly to the IRS.

Our tax laws are complex. According to the President's Panel, "We have lost sight of the fact that the fundamental purpose of our tax system is to raise revenues to fund government." In l913, the Sixteenth Amendment to our Constitution was ratified, which ended all debate as to whether an income tax was constitutional. A few months after the amendment was ratified, Congress enacted an income tax.

Over the years, the tax code has been used by Congress to favor certain constituencies, and the code is replete with exemptions, exclusions and other benefits for individuals and corporations.

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 every tax benefit that is available. Keep in mind that if you are in a 31 percent Federal tax bracket, for example, for every additional dollar you can legally deduct, you will be saving 31 cents that does not have to go to Uncle Sam.

There are a number of real estate 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 until repealed or amended, is encouraged and supported by our Federal Tax Code. Consider this typical scenario: In 1970, you bought your first home for $30,000. You and your spouse had two children, and your first home was just too small. You sold your home for $60,000, and bought another for $80,000.

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 in the year of sale. The rollover was completely eliminated when President Clinton signed into law the Taxpayer Relief Act of 1997. One of the principal features of the great American dream was to encourage homeowners to continue to move up in their lifestyles. However, the Taxpayer Relief Act dramatically changed this concept. As will be seen in subsequent columns, 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.

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 -- concept: 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 2005 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. As this column has reported in the past, both the IRS and this columnist do not support loans which exceed the total equity in your house. It is too dangerous a risk to take, with perhaps your most valuable asset.

    Let us look at this example: Several years ago, you purchased your house for $180,000 and obtained a mortgage (or deed of trust) in the amount of $130,000. Last year, your mortgage indebtedness had been reduced to $120,000, but because the market dramatically increased, your house was 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 $200,000. For tax purposes, your acquisition indebtedness is $120,000 (i.e. the amount of your existing loan). The additional $80,000 that you took out of your equity does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan.

    Several years ago, the Internal Revenue Service ruled 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 $225,000, you are only able to deduct interest on $220,000 of your loan -- the $120,000 acquisition indebtedness, plus the $100,000 home equity.

    The remaining interest is treated as personal interest, and is not 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, it should be noted that 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 2006, you cannot take a deduction for these taxes when you file your 2005 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 2005. 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, that may 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.

  • 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.

    Log in again next week for: "Deducting mortgage interest and points."

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    Benny L Kass

    Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

    Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.


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