Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VI. Personal Expenses, Deductions, and Credits
Chapter 27. Your Residence
After Taxes, Your Home May Be Your Biggest Expense–It May Also Be a Great Tax Deduction
As a general principle, the tax code allows you to take a deduction for expenses that you incur in an effort to create income. The allowance of these deductions encourages people to invest in things that increase their income—increasing taxes as a result. That is why most expenses related to a business are allowed as deductions, when those same items are not deductible when used for personal reasons.
The opposite of this principle is true as well. In most cases the tax code does not allow you to take a deduction for personal expenses—for things that are intended for your personal benefit and not for the purpose of generating income. However, Congress makes exceptions to this rule when it wants to encourage specific behaviors. This is the case with the home mortgage interest deduction and other deductions and credits related to money that you spend on your home. Home ownership has been shown to be a positive factor in society and so Congress has done things through the tax code to make it financially easier to own a home (or at least that is the intent). Seven home-related tax issues are discussed in this chapter:
· The Mortgage Interest Deduction
· The Property Tax Deduction
· Credits related to energy efficiency
· Deductions for home improvements for the disabled
· Home Sale Exemption from Capital Gains
· Foreclosures and short sales
The Mortgage Interest Deduction
To encourage home ownership, the tax code allows for deductions on mortgage interest. Two types of mortgage interest are deductible: acquisition-debt interest and home-equity debt interest.
Acquisition debt is debt used to purchase, build, or substantially improve a qualified residence. Qualified acquisition debt also includes the refinancing of original acquisition debt, as long as the refinancing amount is less than the amount of acquisition debt that existed immediately before the refinance. Only the interest on acquisition debt up to $1 million can be deducted—any additional amount is not deductible under the current rules.
Example Greg purchased his home for $250,000, using $50,000 from his savings for a down payment and using a loan for the rest. All of the interest paid on the $200,000 in acquisition debt is allowed as an itemized deduction because the entire loan was used to purchase the home.
A few years later, Greg decided to make improvements to his home. He borrowed an additional $100,000 from the bank and used $75,000 of it to improve his home (the rest he used to buy a car). He then refinanced his first and second loans to consolidate them into one loan. That brought the total debt on his principal residence to $300,000 ($200,000 original loan + $100,000 new loan). However, he can deduct only the interest that he pays on $275,000 of the loan as acquisition debt ($200,000 for the purchase and $75,000 for substantial improvements).
Bruce, Greg’s wealthy brother, bought his home around the same time as Greg. Bruce’s home cost $2.5 million. Bruce used $1 million of his savings as a down payment on the home and secured a loan for the remaining $1.5 million. Although the entire $1.5 million is considered acquisition debt, only the interest paid on the first $1 million of the loan is deductible as acquisition debt interest because of the limitations placed on the mortgage interest deduction.
Cindy, Bruce and Greg’s prudent sister, also purchased a home. Her home cost $300,000, which she paid for entirely with cash. If Cindy later had an emergency and needed to take out a home equity loan of $200,000 to pay for medical bills, none of the interest on the loan would be deductible as acquisition debt because it was not used to purchase, build, or substantially improve her home. Had she originally used a $200,000 loan to purchase the house and kept her savings in the bank for such an emergency, the interest on that loan would have been deductible.
Mortgage interest is deductible only for the taxpayer’s residence. However, the term “residence” is defined fairly liberally for this deduction. A “residence” could be an RV or boat, as long as the vehicle includes a bathroom and cooking and sleeping accommodations. A qualified residence is also not confined to one home. The tax code actually allows for two residences to be used for this deduction: your principal residence and one other residence (such as a vacation home that is not rented out during the year). Actually, the second residence can be rented out and still qualify for the deduction if you use it for the greater of either 14 days per year, or 10% of the days that it is rented at fair market value.
Caution If you are subject to the Alternative Minimum Tax (AMT), you don’t qualify to deduct a boat (with living quarters) or an RV as a second home—you can deduct interest on a second home only if it is a traditional residence.
The second type of deductible mortgage interest is from loans known as home equity debt. Home equity debt is any debt borrowed for an amount greater than the unpaid principal from the original acquisition debt (or new improvement debt).
Example Jim and Angela purchased a home 10 years ago for $150,000, of which $120,000 was paid for using a loan. They have devoted all of their extra income to pay the loan off quickly and they have only $20,000 left to pay on the loan’s principal. If they were to take out a new loan on the house for $120,000, only $20,000 of the new loan would be considered acquisition debt, and the remainder would be considered a home equity loan because $20,000 was the amount of principal that remained on the acquisition debt just before the refinance.
One significant difference in the rules for home equity debt versus acquisition debt is that the loan can be used to purchase anything and still be deductible. In the earlier example of Greg, the interest from the $25,000 of the loan that he used to buy a car could be deducted as home equity interest, even though it could not be deducted under the rules of acquisition debt.
The amount of home equity debt that is deductible is limited in two ways. First, the home equity debt, combined with the acquisition debt, cannot be greater than the value of the home. If home values drop substantially from their purchase price, this rule can eliminate your ability to claim the deduction for home equity loan interest. The second limitation on the home equity loan deduction is that you can deduct interest only on a maximum of $100,000 of home equity debt.
Tip If you have a loan greater than $1 million, you can treat up to $100,000 of the additional loan value as a home equity loan and deduct it (even if the entire amount was acquisition debt). In the earlier example of Bruce, even though his deduction was limited to the interest from the first $1 million of his loan, he could have taken an additional home equity debt deduction for another $100,000. You can deduct even more interest than the $1.1 million rule allows if part of the home is used for business purposes. See Chapter 17 for more details on this strategy.
The most important thing you can do in cultivating mortgage interest deductions is to keep good records. This is especially important if you refinance your house or take out home equity lines of credit. Track carefully how you use the funds so you can take the proper deduction and back it up in the event of an audit.
You’ll want to keep a couple of other things in mind when planning for these interest deductions as well. First, as is the case with all itemized deductions, the mortgage interest deduction is of no value to you if the standard deduction is greater than all of your itemized deductions combined. Many people receive no benefit from their mortgage interest deduction because they do not have enough deductions to itemize. It is frustrating to me when people in the real estate or mortgage industry tell clients that their mortgage interest will be deductible when it is often not enough of a deduction for them to itemize.
Second, if you are paying the interest on a home for someone else (such as a child or elderly parent), you may not take the deduction for that interest, unless the mortgage is in your name. If you pay the interest but the home is not in your name, the payment is only a gift.
Finally, if you own multiple homes, you can deduct the interest for only two of the homes—your principal residence and one other. The second home you choose for the mortgage interest deduction can be changed on a yearly basis.
Caution Although many advocate remaining in debt in order to retain the interest deduction, I am not one of them. If you have a mortgage and you don’t have the financial ability to pay it off, then you should take full advantage of this deduction. However, if you have the money available to pay off your mortgage, I think you’ll find many more benefits to being debt-free and to owning a home than you will have by retaining the tax deduction. Remember, to get a deduction, you must always spend more money than you will save in taxes—significantly more. If you are in the 25% tax bracket and pay $12,000 in interest, you will save only $3,000 in taxes from the deductions. Even with the deduction you are still $9,000 poorer than you would be had you not had a mortgage.
Points Treated as Interest
At the closing of a loan, an extra fee can be paid to the lender to secure a lower interest rate. This payment is usually referred to as a “point.” The IRS considers points to be the equivalent of interest, and as such they are deductible. In most cases, the deduction must be spread over the life of the loan. For example, if you paid $3,000 in points on a 30-year loan, you could deduct $100 per year as mortgage interest ($3,000 in points ÷ 30 years = $100 per year). However, you can deduct the entire amount paid in the first year if you meet the following conditions:
· The fees are designated as points on the settlement statement.
· The fees are based on a percentage of the loan value.
· The fees are for the purchase of your principal residence (not a refinance or for a second home).
· The fees are paid directly by you (not rolled into the loan).
· It is normal practice in your area to pay the amount of points you paid (you didn’t pay significantly more than most people in order to take advantage of the larger deduction).
· The points are not in lieu of other fees, such as appraisals, title fees, and so on (they are used only to reduce the interest rate).
For a limited time, one other mortgage expense can be deducted. If you purchased your primary residence between January 1, 2007 and December 31, 2013, any mortgage insurance premiums paid during that time are deductible. It is possible that this deduction will be renewed for 2014, but had not yet been at the time that this book went to production. The insurance premiums must apply to the year you paid them, so a prepayment of the insurance for future years would not count. In addition, your ability to take this deduction is phased out if your Adjusted Gross Income (AGI) is between $100,000 and $110,000, and is eliminated thereafter.
The Property Tax Deduction
The tax code also allows you to deduct real estate taxes charged by any state, local, or foreign government. Only the portion of the tax that is based on the assessed value of the property is deductible. Many states and counties also impose local benefit taxes for improvements to property, such as assessments for streets, sidewalks, and sewer lines. These taxes cannot be deducted. However, you can increase the cost basis of your property by the amount of the other non-deductible taxes. Local benefits taxes are deductible if they are for maintenance or repair, or interest charges related to those benefits.
If a portion of your monthly mortgage payment goes into an escrow account from which the lender pays your real estate taxes, you cannot deduct the amount paid into the escrow account. Instead you must deduct the amount actually paid out of the escrow account during the year, which will be listed on the 1098 tax form that the lender sends you at the beginning of each year.
The property tax deduction is not limited by the rules that apply to the mortgage interest deduction. For example, you can claim the deduction for as many properties as you own and pay taxes on (as opposed to the two-residence rule for mortgage interest). In addition, the property tax deduction is not limited by the value of the property. Unlike the $1.1 million limitation placed on mortgage interest, you could own real estate worth $100 million or more and still deduct the entire amount that you pay in real estate tax.
Credits Related to Energy Efficiency
There are two credits available for individuals who make improvements to their homes with items that improve energy efficiency. The first is known as the Residential Energy Efficient Property Credit. This is a non-refundable tax credit intended to encourage the installation of alternative energy equipment in their homes. Equipment that qualifies for the credit includes solar water heaters, solar electricity equipment, fuel cell plants, small wind energy equipment, and geothermal heat pumps. The property must be installed in the taxpayer’s residence and must be located in the United States.
The credit is equal to 30% of the cost of the equipment (however, the credit is limited for fuel cells to a maximum of $500 per half kilowatt hour). If the credit exceeds the amount of tax owed by the individual, the remainder is carried over to the following year. This credit is currently set to expire on December 31, 2016 (the equipment must be installed before that date to qualify for the credit).
Caution Solar water heaters that are used to heat a swimming pool or hot tub do not qualify for the credit. If the water heater heats water for the house and a pool, the cost must be pro-rated and only the portion allocated to the house may be used for the credit.
The second credit for energy efficient property is known as the Nonbusiness Energy Property Credit. This credit expired at the end of 2013, but may be reinstated. The credit has two parts. First, there is a credit of 10% (up to a maximum dollar amount) of the cost of installing energy-efficient improvements that are designed to prevent heat loss or gain, such as insulation, exterior windows, skylights, exterior doors, and metal roofs with special energy-efficient properties.
Second, there is a credit of 100% (up to a maximum dollar amount) of the cost of installation of energy efficient equipment such as water heaters, heat pumps, air conditioners, and biomass fuel stoves as long as they meet certain energy-efficient specifications.
The energy-efficient property credit is severely limited by maximum dollar caps. The maximum credit allowed for windows and skylights is $200. The maximum for heaters is $150. For all other items the maximum is $300. All credits taken for these items combined cannot exceed $500 in the taxpayer’s lifetime.
Caution I have spoken with a lot of people who have fallen prey to salespeople who tout the wonders of this credit. These sellers may say something like, “There is a tax credit for 100% of the cost of this heater, so you can buy it now and get your money back when you file your taxes!” What they neglect to mention is that the credit is 100% of the cost, up to a maximum of $150. The rest of the cost is not eligible for the credit. In addition, some people don’t have taxable income after their deductions are taken into account. This credit is non-refundable, so it will do no good for a person who owes no tax. Whenever you hear a salesperson (or advertisement) spouting tax benefits, be careful. Far too often they are only telling part of the story.
Deductions for Home Improvements for the Disabled
The expense of home improvements or additions that are primarily for medical care or for the disabled are deductible to the extent that they cost more than the value they add to the property. Such improvements may include a wheelchair ramp, handrails in the bathroom, or a powered lift for stairways. They could also include ventilation systems designed to remove harmful particles from the air. There are too many possibilities to list, but the important part is that, if it is necessary for medical purposes, it is deductible on your return to the extent that it does not increase the property’s value. If the improvement adds no value to the home, the entire expense is deductible.
Example Maggie recently had a stroke that left her without full movement in her legs. She is able to care for herself, but is not able to lift her legs over obstacles. For this reason she needed to remodel her bathroom so that the shower does not require her to step into a bath tub. The remodel cost $2,000 and her realtor estimates that the work increased the value of the home by $500. Maggie can deduct $1,500 of the cost as a medical expense ($2,000 total cost – $500 increase in the home’s value = $1,500 deductible expense. (The remaining $500 would be added to the cost basis of her home.
This deduction is actually taken as part of the medical expense deduction and subject to limitations based on AGI. See Chapter 26 to learn more about the limitations imposed on the medical expense deduction.
Home Sale Exemption from Capital Gains
Generally, any time that you purchase an asset for a given price, and then later sell it for a greater price, taxes are levied on that gain (the difference between the purchase and sale price). The tax code provides an important exception (or exclusion) to this rule when it comes to your personal residence. If you meet certain guidelines the gain that you receive when selling your home can be tax-free. Many people have used this exclusion to periodically capture a tax-free gain from selling their home and, over time, use those gains to eventually pay for their new home entirely out of their tax-free gains, resulting in a huge cumulative tax savings.
There are three main guidelines that must be met to achieve tax-free status on the sale of your residence. First, you must have lived in the home as your principal residence for two of the previous five years (from the date of the sale). Second, you must have owned the home for two of the previous five years (which may seem redundant, but it’s not). Third, you cannot claim this exclusion more than once in a two-year period.
The maximum gain exclusion per individual is $250,000, which translates to $500,000 for a married couple. Any gain on the home greater than the maximum exclusion amount would be taxed. The exclusion applies only to the use of the home as a personal residence.
There are many nuances and additional details in this exemption. Most of these are discussed in much greater detail in Chapter 10, which you should definitely read if you plan to sell, or have recently sold, your home.
Foreclosures and Short Sales
The tax code treats a forgiven debt as income—it is essentially the same thing as receiving income that you use to pay off the debt. Nowhere can this fact be more painful than in the foreclosure or short-sale of your home. Not only does it add insult to injury (you lose your home because you are having a hard time financially and then the IRS sends you a big bill), but the tax burden that comes from the debt forgiveness can be extremely high. The difference between the amount of money that you owed and the amount that the lender can sell the home for is treated as ordinary income on your tax return.
Example Damon purchased a home for $450,000 with 100% financing. Soon after he purchased the home there was a collapse in the economy that led to a 50% decrease in home values, as well as a significant decrease in Damon’s income. Damon did his best to hang on to the home, using up much of his savings, before he decided that he would have to let it go into foreclosure. The bank repossessed the home and eventually sold it for $200,000. The following year the bank reported to the IRS that Damon had a “discharge of indebtedness” of $250,000 ($450,000 original debt – $200,000 sale price = $250,000 in debt forgiveness). Barring any exclusions that may apply, Damon will have to report the $250,000 debt forgiveness as income on his tax return for that year.
Fortunately, there are several exceptions to this rule that can help to reduce or eliminate this tax burden. The first exclusion is known as Qualified Principal Residence Indebtedness. This is a temporary exclusion that was enacted in the wake of the 2008 economic crisis. The rule makes it so that any debt forgiveness for a home that occurs between January 1, 2007 and December 31, 2013 is not subject to income tax or included in an individual’s income. To qualify for this exclusion, the debt must be acquisition debt (only the portion of the loan used to purchase the home) for the individual’s principal residence and is available for only up to $2,000,000 of debt forgiven. This exclusion is expected to be retroactively extended through 2014.
In addition to the temporary exclusion, there is another permanent exclusion that may apply. The taxpayer need not recognize income if he or she is in bankruptcy or is insolvent. (Insolvent means that the taxpayer’s debts exceed the market value of his or her assets immediately before the forgiveness of the debt). However, the exclusion for insolvency is applicable only to the extent that of the insolvency.
Example Damon stopped making payments on the home when he realized that there was no way he would be able to keep it, which was a few months before he would have completely wiped out his savings. At the time the bank foreclosed on the home Damon had $10,000 left in the bank and a car that he owned free and clear, which was worth about $5,000. Damon had no other assets debts. At the time of the foreclosure Damon was insolvent by $235,000 ($450,000 debt – $200,000 home value - $10,000 in savings – $5,000 value of car = $235,000 insolvent).
The bank charged Damon with $250,000 of debt forgiveness; however Damon will have to report only $15,000 of that as income on his tax return because that is the extent to which the debt forgiveness exceeded his insolvency.
With each of these exclusions, the basis of the home is reduced by the amount of debt forgiveness that was excluded from income, which determines any gain that is captured when the home later sold.