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TAX BENEFITS OF HOME OWNERSHIP

Jan 2001

Financing

  • Mortgage interest: interest paid on a mortgage loan to acquire or improve a principal residence or second residence is fully deductible to the extent of $ 1,000,000 of acquisition indebtedness. Interest on home equity financing is limited to $100,000 of debt.

    • - Property must secure the loan to qualify.
    - Generally should receive Form 1098 from lender; IRS compares mortgage interest similar to interest and dividends reported on 1099's. Care should be exercised so that tax return matches amounts reported to IRS by lenders.
    - Seller financing requires that the homeowner report the seller's name, address, and TIN.

  • Points: points paid on the acquisition debt for a principal residence are generally deductible in the year paid; the IRS follows the following administrative rules in determining whether points are deductible:

    1. Points must be designated as points on the closing statement ("loan origination fees," "loan discount,""discount points" or "points" are appropriate designations).

    2. Points must be calculated as a % of loan amount.

    3. Points must be paid to acquire or improve the taxpayer's principal residence and the loan must be secured by the residence.

    4. Points must be paid by the taxpayer and not deducted from loan proceeds; however, a very important exception applies where seller pays the points and homeowner reduces the basis of the residence.

    5. Points must conform to established mortgage business practices in the area.

Points paid on refinancing, rental property, secondary residence or points deducted from loan proceeds are deducted over the term of the loan as additional interest.

Prepayment penalties on mortgage loan are treated as additional interest when paid.

IRS Ruling in Favor of Taxpayer — the IRS has recently ruled that a new home purchaser paying points on a late year closing could write off the points over the term of the loan. The buyer's total itemized deductions including points paid were less than standard deduction and was unable to benefit in the year of purchase from the points.

Real Estate Taxes

- Real estate taxes are deductible by the owner of the property in the year paid by a cash basis taxpayer.
- Must be prorated between the buyer and the seller in the year of sale or transfer according to period of ownership during the year.
- Taxes paid on another's property are not deductible.
- IRS has ruled that MUD taxes are generally not deductible on the basis that the MUD only benefits the properties on which the taxes are assessed. Deduction will be allowed to the extent the taxpayer can show that the tax assessment is allocable to the interest or maintenance charges incurred by the MUD.

Please note that mortgage interest, points, and real estate taxes are itemized deductions subject to phase-out by high income taxpayers and thus the timing of the deduction to the extent it can be controlled should be planned to maximize the tax benefits.

- Phase-out occurs to the extent that Adjusted Gross Income (AGI) exceeds $128,950 in 2000.



Non-deductible items:

1) Mortgage insurance (PMI)

2) Title insurance

3) Legal fees, filing and recording fees

4) Miscellaneous closing costs

5) Hazard and flood insurance

If rental property, items 1) and 2) may be amortized over the term of the loan; items 3) and 4) may be allocated to basis for depreciation purposes; and item 5) will generally be deductible in the year paid.

Sale of a Home
Sales occurring after May 6, 1997 have new rules with respect to the treatment of gains on the sale of a principal residence. Losses continue to be non-deductible.


- Prior rules permitted the rollover of the gain on the sale of a residence to the extent the proceeds were used to purchase a replacement residence; taxpayers over age 54 were permitted a once in a lifetime exclusion of $125,000.
- New rules for sales occurring after May 6, 1997 provide for no-recognition of gain to the extent of $500,000 for a married couple and $250,000 for a single person. Exclusion may be applied once every two years.

Most sales will not require reporting on Form 1040.

- Two year requirement: critical test is that the property be owned and used in two of the previous five years as the principal residence of the seller; in the case of divorcing couples periods of prior ownership and use as a residence by the other spouse may be attributed to the selling spouse for this test if residence is transferred incident to divorce to that spouse.
- Special Transition Rule: the two-year ownership and use test is not required in the case of a principal residence owned on August 5, 1997 and sold during the two year period ending August 5, 1999. Seller prorates the exclusion based upon holding period.

- Special Hardship Relief: the two-year rule is relaxed and the exclusion ($500,000/$250,000) is prorated over the period of use/ownership in the case of a homeowner forced to sell due to a hardship. Hardship includes a job transfer, illness, or other unforeseen hardship yet to be defined by the IRS.

For sales of residence not qualifying for or in excess of exclusion amounts, preferential capital gains treatment (20% maximum tax rate) may apply if held for at least one year.

Early Distributions from IRA's to Buy New Home
Beginning in 1998, the 10% penalty for early withdrawal (before age 59 ½), is waived for a "qualified first time homebuyer distribution".

- Any distribution that is used within 120 days after it was received to pay the qualified acquisition costs of a principal residence of a first time homebuyer.
- Distributions up to $10,000 qualify.
- First time homebuyer is an individual who has had no present ownership interest in a two year period ending on the date of acquisition.
- May include an individual, his/her spouse, child, grandchild, or ancestor of the individual or his/her spouse.
- Date of acquisition is the date a binding contract is executed.