Although we are in a new year, by and large our tax laws remain the same: complex.
Despite a lot of rhetoric last year, there were no major changes to the tax code dealing with real estate. And because this is an election year, I seriously doubt that we will see any changes this year, although there will be a lot of talking about tax reform.
So on April 15, or later if you obtain an extension, most Americans--and every homeowner--will file income tax returns. Fortunately for most homeowners, there are a number of tax advantages still available, as long as you know about them and report them properly to the IRS. Fortunately, too, Congress still understands that American homeownership is still the American dream.
Whether you file your 1999 tax return immediately or wait until the last moment, it is important to understand and take advantage of every tax benefit that is available.
First, some basic definitions:
* Gross profit: This is the difference between what you originally paid for your house and the sales price.
* Net profit: You subtract from gross profit the cost of 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."
* Basis: The initial cost of the property, plus any improvements you have made over the years.
Homeownership continues to be endorsed, encouraged and supported by the federal tax code. Consider this typical scenario: In 1975 you bought your first home for $35,000. You and your spouse had some children and your first home was just too small. You sold your home for $65,000 and bought another for $75,000.
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 eliminated when President Clinton signed into law the Taxpayer Relief Act of 1997. It was replaced by a tax exclusion that is even more favorable for many homeowners. As will be seen in subsequent columns, homeowners are now permitted to exclude up to $250,000 of profits made on their principal residence, or $500,000 for married taxpayers filing joint returns. This exclusion is not limited to any one sale, but can be taken every two years.
With this more generous exclusion, Congress also repealed the "once in a lifetime" exemption, whereby homeowners older than 55 were given an absolute exclusion of up to $125,000 of the overall profit made on the house.
For those who own homes and are preparing to file 1999 tax returns, here is a list of the itemized tax deductions available to the average homeowner:
Interest on mortgage loans on a first or second home is fully deductible, up to certain limits--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 fooled 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. Any other excess, though, may qualify as a home equity loan.
Let us look at this example: Several years ago, you bought your house for $175,000 and obtained a mortgage, or deed of trust, for $125,000. Last year your mortgage indebtedness was reduced to $110,000, but your house was worth $275,000.
Because rates were low last year, you refinanced and were able to get a new mortgage of $180,000. The acquisition indebtedness is $110,000 (for example, the amount of your existing loan). The additional $70,000 that you took out of your equity does not qualify as acquisition indebtedness, but since it is less than $100,000, it qualifies as a home equity loan.
Several years ago the Internal Revenue Service ruled that a taxpayer does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. But there are limits. If you borrowed $220,000, for example, you would only be able to deduct interest on $210,000 of your loan--the $110,000 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 from a home equity loan. You no longer have to justify your loan as meeting certain medical or educational requirements.
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 2000 taxes, you cannot take a deduction for these taxes when you file your 1999 return.
If you bought a house last year, however, you may have reimbursed your seller for a portion of the prepaid taxes through the end of 1999. Review your settlement sheet carefully. Line 106 on page 1 of that statement should reflect this tax allocation. Since this was a current payment by you for real estate taxes, it is a deductible item. Be especially careful--when you receive your annual statement from your lender showing the amount of taxes paid last year, that allocation may not be included in that annual statement.
When you obtain a mortgage loan, you often have to pay charges known as points. Whether referred to as "loan origination fees," "premium charges" or "discounts," these are still points. Each point is 1 percent of the amount borrowed; if you obtain a loan of $210,000, each point is $2,100.
In 1992, the IRS ruled that it will permit a deduction for points paid during a taxable year if the following five requirements are met:
* The settlement sheet must clearly designate the amount of points incurred.
* The amount must be computed as a percentage of the principal loan amount. In other words, each point must represent some identifiable percentage--for example, 1 percent, 3 percent--and not just a flat, arbitrary fee.
* The points must be paid to acquire the taxpayer's principal residence, and the loan must be secured by that residence.
* The points must be paid directly by the taxpayer, and may not be borrowed as part of the total loan transaction. Although the IRS ruled in 1991 that points do not have to be paid separately to be deductible, it is still advisable to write a separate check to the lender or have the title attorney reflect on the settlement statement that these points were paid by you.
* The amount paid must conform to the business practice of charging points in the area in which your house is located.
The IRS has also ruled that even if points are paid by sellers, they are still deductible by the home buyer.
Next: More on points and other tax deductions
Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.