January 20, 2005  Email this  Print this
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PREPARATION
Homeowners' Tax Guide
Homeowners can claim a slew of write-offs to lower their tax bills -- as long as they itemize. There are deductions for mortgage interest, mortgage points and real-estate tax payments. And if you sell your home, most likely you won't have to pay taxes on the profit. If you bought a home last year, you might even get to write off expenses you didn't pay. So make sure you get all the tax breaks you have coming.
Mortgage interest
Mortgage interest is any interest you pay on
- A loan to buy a home (primary or second home)
- A home equity line of credit
- A home equity loan
To write off mortgage interest, you must itemize deductions on Schedule A.
Interest on up to $1 million in mortgage debt and up to $100,000 of home-equity debt may be deductible.
If you take a "cash-out refinancing" -- where you borrow more than the remaining balance on your mortgage -- the extra money will be subject to the limit for home-equity debt. Other home-equity loans and lines of credit also count toward the $100,000 cap.
There is one exception to this rule, though. Any home-equity money used for home improvements becomes acquisition debt, and is subject to the $1 million acquisition debt limit. Say, for example, you owe $780,000 on your home but borrow $900,000 when you refinance. That first $780,000 is considered acquisition debt; the remaining $120,000 is home-equity debt and interest on only $100,000 would be deductible. However, if that $120,000 is used to finance an addition to the house, then the entire $900,000 would be considered acquisition debt and treated to the $1 million maximum.
One other caveat: You won't be able to deduct all of your home-equity debt if the size of your home-equity debt plus your acquisition debt is greater than 100% of the fair-market value of the house.
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Mortgage points
In the year that you buy a house, you can deduct the points paid to get your loan (even points the seller paid on your behalf). Because a point is 1% of the mortgage amount, this could save you lot of money. For example, $2,500 in points will save you $625 if you're in the 25% bracket. You'll probably get a break on your state tax return, too.
Until a few years ago, when the seller paid the points, nobody got a deduction. But now, the IRS says buyers usually can pretend that they paid the points themselves.
If you pay points to refinance, though, you must spread the deduction over the life of the loan. For example, say you paid two points on a $200,000 loan ($4,000) in 2004. If the loan were for 30 years, then you'd only be able to deduct $133 per year ($4,000 divided by 30).
But if you refinance again or sell your home, you can deduct the remaining value of the points on that year's tax return. So, using the example above, let's say you refinanced again in 2004. On your 2004 tax return you could deduct the remaining $3,867 ($4,000 minus $133) in addition to your deduction for any points paid on the new loan.
There's an exception that might deny you that big write-off, though.
The IRS says that if you refinanced the loan with the same lender -- as homeowners often do to hold down costs -- then the points from the first refinancing are not immediately deductible. Instead they are to be added to the points charged on the second refinancing and deducted over the life of that loan.
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Real estate tax deduction
Real estate taxes paid on your main home (or second home) generally are deductible. According to the IRS, deductible real estate taxes include any state, local, or foreign taxes on real property levied for the general public welfare. Deductible real estate taxes do not include taxes charged for local benefits and improvements that increase the value of the property.
If you bought a house in 2004, you may deserve a bigger real estate tax deduction than you think you do. If the seller paid real estate taxes in advance for a period during which you actually owned the home, include that amount in your deduction -- even if you didn't reimburse the seller.
As far as the tax law is concerned, you paid tax, whether you did it directly or through a higher price for the house. Check your settlement sheet to make sure you don't overlook a money saver.
What about other costs associated with buying, like the title insurance premium or the appraisal fee, a recordation charge or the lawyer's' bill? Sorry, but none of them is deductible.
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Home-sale profits
If you sold your home last year, there's a good chance you don't have to tell the IRS about the deal -- even if you made a healthy profit.
The law makes the first $250,000 of profit on the sale of a home tax-free if you meet a couple of tests. The quarter-million-dollar limit is for single returns; it doubles to $500,000 if you're married and file a joint return with your spouse.
You qualify for tax-free profit on your home sale if:
- You owned and lived in the house for two of the five years leading up to the sale; and
- You did not sell another house -- and claim tax-free profit on the deal -- in the two years leading up to the time you sold this house.
If your place sold for more than $250,000 or $500,000, you subtract your "basis" from the amount realized to see if you have a taxable profit.
Your basis is what you paid for the house, plus the cost of any improvements over the years -- and minus any profit from the sale of previous homes that, under the old law, you rolled over into this house.
If you have a taxable profit, report it on Schedule D, the same form you use to report the sale of stocks, bonds and mutual funds.
What if you didn't live in the house for two of the five years leading up to the time of the sale? Depending on why you moved, you still may be able to qualify for an exclusion that protects all of your profit. The IRS has a lengthy list of "good reasons" that can earn you a partial exclusion.
Some people think a partial exclusion means that part of the profit would be tax-free. But that's not necessarily so. It's possible that every dime of profit will be tax-free. The partial exclusion doesn't mean part of the profit is protected, it means your profit is protected by part of the $250,000/$500,000 exclusion.
Say, for example, that you owned your home for just one year before selling it because you moved to take a new job. Because you owned and lived in the house for half of the two-year period, you get half of the exclusion. That means the first $125,000 of profit is tax-free if you're single and $250,000 if you're married and file a joint return. (If you made more profit than that in a year, congratulations!)
In the past, the only sales that qualified for a partial exclusion were those connected with a move to take a new job or a move connected with a change in your health. But the IRS has issued a list of "unforeseen circumstances" that can also lead to a qualifying sale. They include:
- Death
- Divorce or legal separation
- Becoming eligible for unemployment compensation
- Change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses
- Multiple births resulting from the same pregnancy
- Damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism
- Condemnation, seizure or other involuntary conversion of the property
You'll find a worksheet in IRS Publication 523 to help figure the exact size of your exclusion based on how long you owned and lived in the house. If all your profit is tax-free, you don't have to report the sale to the IRS at all.
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Use of home for business
There's good news if you used part of the house for business purposes. Say you had a home office for which you deducted expenses or rented out a room. In the past, homeowners in that situation couldn't count profit from the business part of the house as tax-free home-sale gain. Instead it was taxed as profit from commercial real estate. But in 2003, the IRS decided to forget about that distinction.
You no longer have to allocate profit between the home and business part of the house. This change of heart was retroactive, too. So if you reported taxable profit from the sale of a home because of the old home office rule, you can file an amended return to retrieve tax paid with your 2000, 2001 or 2002 return. (The part of the profit attributable to depreciation on the business part of the house is still taxable.)
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Property damage
Victims of disasters who suffered uninsured property damage may get tax some relief, especially if they live in a presidentially declared disaster area. Disasters include floods, hurricanes, tornadoes, fires, earthquakes and even volcanic eruptions.
Casualty losses are generally deductible only in the year the casualty occurred. However you can take a retroactive deduction for the year preceding a casualty loss if it occurred in a presidentially declared disaster area. Amending your previous year's return would guarantee you a refund check from the IRS.
To figure your deduction you must first reduce each loss by $100 and then subtract 10% of your adjusted gross income. (Those residents who suffered from two storms must reduce their loss by $200.) You can deduct the remainder.
If your loss is $35,000 from a storm in 2004, say, and your AGI for 2003 was $75,000, your loss would be $27,400. (Because of the AGI reduction you'll probably want to claim the write-off in the year in which your income is lower.)
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Rental home-sale profits
When you sell a rental property, you'll probably owe tax on the profit, and figuring that profit can be a bear.
First, you'll need to establish your tax basis. That's basically what you paid for the house, plus the cost of capital improvements (a new roof, for instance, or installation of central air conditioning), minus past depreciation deductions.
That's right, you must tote up all the depreciation deductions you claimed during the years you rented the place.
Subtract the basis from the proceeds of the sale to find your profit.
Profit attributable to appreciation is taxed at 15% as a long-term capital gain. The part attributable to depreciation (remember, every dollar used to reduce the basis for depreciation adds a dollar to the profit side of the ledger) is taxed at 25%.
You'll report the sale on Form 4797 and figure the tax bill on Schedule D. If the profit is significant, you may need to make estimated tax payments in September and January, too.
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Rental improvements and repairs
If you're doing a major overhaul before renting the property, the whole project is considered a home improvement. The IRS defines home improvements as steps you take that add to the value or the life of the property (such as building a deck or installing central air). The cost of improvements you make before you start renting property are added to your cost basis and can be depreciated after the property is available for rent.
Residential rental property is depreciated over 27.5 years, which means you can deduct 3.64% of your cost basis each year. Your basis is essentially the price of the property (minus the value of the land) plus any improvements you make before it's ready to rent.
The rules are different for repairs, defined as things you do to keep the property in good condition, such as repainting rooms or fixing broken windows. Costs for repairs you make after renting the house can be deducted in the year you pay them.
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