Let’s be honest: April 15th is a day of reckoning, the moment when we find out what we really owe for taxes. In households nationwide wallets are drained and many who were rich on the 14th are greatly impoverished by the 16th.
But for those with real estate the load is made lighter by tax rules which encourage the ownership of homes and investment property. Such rules are not only good for homeowners, they’re also good for the country: About 20 percent of all economic activity nationwide is related to real estate, so policies which encourage real estate activity help everyone.
It seems that almost every year changes to the tax code require the production of new forms and a re-education process. That said, the real estate basics remain in place and they’re good news for buyers, sellers, borrowers and owners.
Mortgage interest is generally deductible.
The IRS says there are three categories of deductible home mortgage interest:
- Mortgages you took out on or before October 13, 1987 (called grandfathered debt).
- Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called home acquisition debt), but only if throughout 2005 these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately).
- Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home (called home equity debt), but only if throughout 2005 these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2).
Substantial profits can be sheltered when a prime residence is sold.
When a prime residence is sold, up to $500,000 in profits can be sheltered from federal taxes if married, $250,000 if single, providing the home has been used as a prime residence for two of the past five years. Generally this deduction cannot be used more than once every two years, according to the IRS.
There are also provisions which may be helpful to individuals who must sell a prime residence in less than two years. Under the 2004
safe harbor rules, individuals may be able to get some capital gains relief under certain circumstances, such as being forced to move because a job has been relocated at least 50 miles or a home that must be sold because of multiple births resulting from the same pregnancy.
Also, individuals in the Armed Forces and the Foreign Service may be entitled to special consideration under the Military Family Tax Relief Act of 2003 (MFTRA). For instance, you may have longer to take a capital gains deduction or to amend a tax return. There are other provisions under MFTRA that also may be helpful, so check with a tax professional for specifics.
Lastly, please see the information below regarding the new tax credit of up to $6,500 which is available to certain owners who obtain a contract to buy their current residence before April 30, 2010 and close before June 30, 2010.
Points may be deducible by both buyers and sellers.
Picture a situation where a home is sold for $500,000 and the owner — to help close the sale — offers to pay 1 point for the buyer. If the property was financed with a $350,000 mortgage, a point would be worth $3,500. According to the IRS, “the seller cannot deduct these fees as interest. But they are a selling expense that reduces the amount realized by the seller.”
Interestingly, in this situation the buyer can also deduct the points when the home is sold.
“The buyer,” says the IRS, “reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them.”
In effect, the seller gets to write-off the $3,500 cost by reducing any profit from the sale. The buyer essentially lowers the purchase price of the property when the home is sold at some point in the future — thus increasing the size of any profit. However, since up to $500,000 in sale profits may be untaxed, most buyers will effectively never pay a tax on the seller’s contribution for points.
If a prime residence is refinanced then the deal with points is different: The expense of a point must deducted over the life of the loan. If the home is sold before the loan term ends, then any cost not deducted for points can be used to reduce owner’s profit from the sale.
Home offices may be deductible.
If a portion of your home is used regularly and exclusively as your principal place of business or for the convenience of your employer it may be possible to write off a portion of such costs as mortgage interest, property taxes and utilities. There are a number of tests which must be met to take this deduction, see IRS Publication 587, Business Use of Your Home for details.
In some cases there may be tax advantages associated with not deducting your home office in the year or two before you move. Speak with a tax professional for specifics.
Mortgage insurance premiums may be deductible.
Mortgage insurance premiums should be deductible. The catch? Not all premiums are deductible by all borrowers. In general, the rules look like this:
- The deduction applies to loans made after January 1st, 2007.
- The deduction applies to both private mortgage insurance (MI) as well as mortgage insurance through the Federal Housing Administration (FHA), the Veterans Department (VA) and the Rural Housing Administration.
- The deduction applies to acquisition indebtedness, meaning debt used to acquire a home.
- If you refinance remaining “acquisition indebtedness” then you can write off mortgage insurance on the new debt.
- You can take the deduction if you’re married, file jointly and have a gross adjusted income of $100,000 or less. If you’re single or married and filing separately the income limit is $50,000.
- The deduction phases out once income limits are passed. For married couples, the deduction is reduced by 10 percent for each $1,000 in income over $100,000. This means there is no deduction for incomes above $110,000. For singles and those married and filing separately, the deduction is reduced by 10 percent for each $500 in additional income — this means there is no deduction above $55,000.
- The mortgage premium write-off begins January 1, 2007 and is scheduled to end December 31st, 2010. However, the program is likely to be extended.
- Speak with a tax professional for specifics.
The Katrina Emergency Tax Relief Act of 2005 provides extensive tax benefits and assistance to those who were victims of hurricanes Katrina, Rita and Wilma. For details, go to the IRS Katrina relief page or call 1-866-562-5227.
If you have been in a natural disaster — a flood, hurricane, tornado, etc., contact your local congressional office to see if special tax help is available. Links to congressional offices can be found by pressing here.
Mortgage Forgiveness Act
Traditionally if you do not pay a mortgage in full any money not paid is regarded as “imputed” income — income which is taxable. However, with the passage of the Mortgage Forgiveness Debt Relief Act of 2007, a bill sponsored by Rep. Charles Rangel (D-NY), if you can negotiate a partial pay-off with a lender, the amount forgiven will not be taxed by the federal government.
This legislation makes sense because people who have lost their homes, been foreclosed or gone bankrupt have no money to pay. However, the maximum write-off is limited to forgiveness worth no more than $2 million (not a problem for most folks) and — more importantly — the rule applies only to a principal residence.
Important: This legislation was expected to expire on December 31, 2012, however it was extended until December 31, 2013. At this writing, in early 2014, mortgage relief legislation does not exist. Will it be reinstated? We don’t know. For specifics be certain to speak with a tax professional.
$8,000 Tax Credit For First Time Buyers Extended Until April 30, 2010
Under the FHA reform package passed by the Congress during the summer of 2008, first-time home buyers could be entitled to a tax credit equal to 10 percent of the purchase price of the residence. This credit is limited to $7,500 for married couples and single taxpayers but can be no more than $3,750 for married individuals filing separately.
Since most homes are valued at more than $75,000 the credit will likely be used up with the purchase of a home or condo. The property must be occupied after April 9, 2008 but before July 1, 2009 to qualify. Also, a “first-time” buyer is defined as someone who has not held title to real estate for at least three years. The credit phases out for married couples earning above $150,000 a year and for singles earning more than $75,000.
The $7,500 is a credit against taxes due to Uncle Sam. If you owe $10,000 to the IRS you can deduct up to $7,500. But, when you sell the property the $7,500 must be repaid over 15 years — that’s just $500 a year at some point in the future.
Okay, it’s really a $7,500 loan — without interest and when you really need it.
2009 First-Time Homebuyer Credit (Part 1)
In 2009 the deal changed. Under the American Recovery and Reinvestment Act of 2009 the credit amount was raised to $8,000 and NO repayment is required if a first-time homebuyer purchases a residence before December 1, 2009. There is still an income phase out and buyers must own their homes for at least three years.
2009 First-Time Homebuyer Credit (Part 2)
In November 2009 the deadline for the first-time homebuyer credit was extended under the Worker, Homeownership, and Business Assistance Act of 2009 from December 1, 2009 to include contracts made before April 30, 2010 and closed before June 30th.
Also, the income cap to get the full credit was raised from $75,000 if single or $150,000 if married to $125,000 for singles and $225,000 for joint filers. Above the $125,000/$225,000 levels the credit phases out to nothing at $145,000 for singles and $245,000 for couples.
New Credit for Existing Home Sellers
The November 2009 legislation also created a new tax credit for existing home sellers. In basic terms, if you have owned your home for five consecutive years out of the last eight you can get a tax credit for as much as $6,500. The contract to sell your replacement residence must be signed before April 30, 2010 and the deal must be closed before June 30, 2010.
For specifics regarding the November 2009 changes, speak with a tax professional and get a copy of IRS Form 5405. Also, see the IRS first-time homebuyer site for details regarding the new legislation.
Investment real estate can generate substantial write-offs.
If you own rental property you must seek a fair market rental for your property. You may generally deduct mortgage interest, property taxes, repair costs, management by an outside party, depreciation, advertising, insurance, utilities, legal services and other expenses.
It’s possible with rental properties to have both a positive cashflow and a loss for tax purposes. However, the ability to use real estate losses to reduce overall taxes may be phased out as income rises above $100,000.
If a rental involves relatives special rules and restrictions may apply. Check with a tax pro for details.
A 1031 exchange may allow investors to defer all capital gains taxes.
With a 1031 transaction, investment property is exchanged for “like” real estate. The basic requirements are that within 45 days after the “relinquished” property has been sold, a “replacement” property must be identified. The identified replacement property must then be acquired within 180 days after the sale of the relinquished property.
What’s important about a 1031 exchange is that the capital gains tax on the relinquished property is deferred — but it does not disappear. What really happens is that the basis for the new property (the “replacement property”) is reduced by the adjusted value of the “relinquished property” (the old property).
A 1031 exchange is complex and requires the services of a “qualified intermediary.” Among other tasks, a qualified intermediary holds the money from the sale of the relinquished property and applies it to the purchase of the replacement real estate. This must be done because under the rules for 1031 exchanges, the seller of a relinquished property cannot touch money from the sale — it must be held by the qualified intermediary.
Accounting for a 1031 exchange is also complex. Essentially there is a need to figure out the sale value of the relinquished property, add back depreciation and account for financing. Ed Horan, a well-known exchange authority and the author of How To Do a Like Kind Exchange of Real Estate, has posted a free 13-page exchanging guide with an accounting worksheet that’s well worth reviewing before meeting with a tax pro.
Death of a Spouse
The capital gains write-off for the sale of a home is $500,000 if married and $250,000 if single. But what happens if a spouse dies?
For years the rule has been that if the couple’s home was not sold by December 31, 2007 then the surviving spouse would be treated as a single home seller. In other words, the maximum write-off would go from $500,000 to $250,000.
There is a certain logic to this approach — and also a certain cruelty. If a spouse dies on November 30th the surviving spouse would have about four weeks to sell the home. This hardly seems right but now the rule has been changed.
Under new legislation passed by Congress, after December 31, 2007 surviving spouses will now have two years from the date of passing to sell the property and still qualify for the $500,000 write-off.
For 2009 you can give someone as much as $13,000 per year, tax free. This is up from $12,000 in 2008. For gift information from the IRS, press here.
Sources and Publications
You can be certain that the information presented here is not a substitute for professional advice. As always with taxes, nothing is ever simple or easy. Speak with a qualified tax professional for specific advice — an enrolled agent, a CPA or an attorney who specializes in tax issues.
Also, the IRS itself has excellent information at its website, www.irs.gov, by phone at 1-800-829-1040 and with specialized publications such as those below:
- Publication 523, Selling Your Home
- Publication 527, Residential Rental Property
- Publication 530, Tax Information for First-Time Homeowners
- Publication 535, Business Expenses
- Publication 587, Business Use of Your Home
- Publication 936, Home Mortgage Interest Deduction
- Publication 946, How To Depreciate Property