“There is no such thing as a good tax.”
— Winston Churchill
Homeowners got an income tax reprieve on Jan. 1 when Congress enacted the so-called “fiscal cliff” legislation.
Home mortgage interest remains deductible, and the exclusion of gain up to $500,000 from the sale of a principal home is very much alive, even though many influential organizations, including the Simpson-Bowles deficit commission, strongly recommended limiting (or even eliminating) those two sacred tax breaks.
So let’s take a look at them.
Did you sell your home last year? Although many people in this area were underwater, property values actually increased in 2012. Under the law, you can exclude up to $500,000 of your profit if you are married and file a joint tax return, or up to $250,000 if you file a separate tax return.
You pass two important tests: You must have owned the home for at least two years during the five-year period prior to the date of sale. (If you are married, only one of you has to meet that test.) And you and your spouse must have lived in the house for at least two years. In the event of a divorce where one spouse is awarded the house, the ownership requirement will include any time accrued when the former spouse owned the property.
What if your spouse dies and you want to sell the family home? If you did not remarry, you can still qualify for the up-to-$500,000 exclusion if the sale takes place no more than two years after the death, and if you and your spouse met the use and ownership requirements at the time of the death.
But what if you have to sell and cannot pass the two-out-of-five-years test? There are some “safe harbors,” and if you meet IRS qualifications, you may claim a partial exclusion.
The qualifications include a change in employment: if the primary reason you had to sell is that your new job will be at least 50 miles farther from your current home. Another exclusion is health: if your doctor recommends a change of location, either to facilitate treatment or to provide medical or personal health care. The doctor’s recommendation can be to any qualified individuals, which can include parents, children, grandparents, even uncles and aunts.
There is a catch-all third exclusion for “unforeseen circumstances.” Examples include death, destruction of the home, unemployment, divorce or legal separation, or multiple births resulting from the same pregnancy.
The partial exclusion requires doing some math. It is equal to the number of days of use times the quotient of $500,000 divided by 730 days (which is two full years). If you are single or do not file a joint tax return, replace the $500,000 with $250,000.
Some homeowners in this area will make a profit of more than the exclusion that is allowed by law. If that’s your situation, you will have to pay capital gains tax on the amount of gain over the exclusion. Thus, it is important to make sure you have included all improvements and all legitimate expenses in calculating your tax basis. Oversimplified, the tax basis is the price you paid to buy the home plus such items as closing costs, real estate commissions and improvements.
The second benefit that survived is the right to deduct the interest you pay on your mortgage. This can get complicated.
The IRS requires that the debt be on a “qualified home.” Clearly, that includes your main house, where you and your family reside. But it also can include a second home (with limitations for rental property; you must live in it for more than 14 days or 10 percent of the number of days during the year that the home is rented, whichever is longer). And if your boat or motor home has toilet, sleeping and cooking facilities, the interest you pay also can be deducted.
If your mortgage was dated before Oct. 13, 1987, and you are still paying interest on it, you can deduct all of the interest without limitation. This is referred to as “grandfathered debt.” However, if your mortgage was obtained after that date, you can deduct interest only on the amount of the loan up to $1 million. Above that amount, you can still deduct the interest you pay on another $100,000 of the loan. While this is referred to as home equity debt, the IRS has allowed homeowners to deduct the interest up to the full $1.1 million even if there is no separate home equity loan.
If you fall into the alternative minimum tax category, talk to your financial advisers, because you will not be able to deduct over the $1 million threshold.
Did you pay points? Look at your settlement statement, called the HUD-1. If there is a line item listing a loan origination fee, maximum loan charges or loan discount, those are points. Typically, one point is the equivalent of 1 percent of the total loan, and lenders will usually lower your interest rate by 1 / 8 to 1 / 4 percent for every point you pay.
You cannot deduct points in the year you pay them; you have to deduct them over the life of the loan. So if you paid $4,000 in points to obtain a 30-year loan, you can deduct $133.33 each year ($4,000 divided by 30). Of course, if you pay off the loan earlier, any remaining amount can then be deducted in that year.
There are special situations, such as if you paid points on a refinance that was used to improve your home. In that case, you may be able to claim more of a deduction.
One additional benefit included in the Jan. 1 legislation: Congress extended the right to deduct mortgage insurance premiums through 2013 and retroactively covered tax year 2012. If your income is below $110,000, you should be able to deduct the premiums you pay for mortgage provided by the Veterans Administration, the Federal Housing Administration and private mortgage insurance companies.
What about reverse mortgages? The money you receive — either by way of a lump sum or periodic payments — is not considered income and thus is not taxable. It is treated as loan advances on the equity in your home. However, when the loan is paid in full — either because the house is sold or someone dies — that is when you technically pay back the interest, and you might be able to deduct a portion of the money. However, a reverse mortgage loan is generally subject to the $100,000 limitations on home equity debt.
Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining legal counsel. 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, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036.