“There is no such thing as a good tax” – Winston Churchill
Homeowners were given a reprieve when Congress, on January 1st of this year, enacted the so-called “fiscal cliff” legislation. Home mortgage interest can still be deducted and the up-to $500,000 exclusion of gain when you sell your principal home is very much alive, despite the fact that many influential organizations, including the Simpson-Bowles deficit commission, strongly recommended limiting (or even deleting) these two sacred tax breaks.
Let’s look at these two tax issues?
Did you sell your home last year? Unfortunately, although many people in this area were under water – namely their home was valued at less than their mortgage – property values did actually increase last year. 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.
There are two important tests that you have to meet: (1) ownership – 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 this test; (2) use – 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 given ownership pursuant to a divorce decree or separate agreement, the ownership requirement will include any time that the former spouse actually owned the property.
What if your spouse dies and you want to sell the family home? If you did not remarry before you sell, 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 you and your spouse met the use and ownership tests at the time of the death.
But what if you have to sell and cannot meet the two-out-of five test? There are some “safe harbors” – if you fall within the IRS guidelines, you are safe to claim a partial exclusion. These include : (1) a change in employment — the primary reason you had to sell is that your new job will be at least 50 miles further from your current home; (2) health – your doctor recommends a change of location, either to facilitate the treatment or to provide medical or personal health care. It is to be noted that the doctor’s recommendation can be to any qualified individual, which can include parents, children, grandparents, and even uncles and aunts.
There is a catch-all third exclusion called “unforseen circumstances”. According to the IRS, this is where the “primary reason for the sale is the occurrence of an event that you could not reasonably have anticipated before buying the occupying the house”. Examples include death, your home is destroyed, 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.
For more information, discuss the matter with your financial advisors. For many homeowners in this area, they will make a profit of more than the exclusion that is allowed by law. In that case, 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, tax basis is the cost of your home, plus such items as improvements, closing costs, and real estate commissions. You can also find helpful information in IRS Publication 523, “Selling Your Home” 2012. (IRS.Gov/publications)
The second benefit that survived is the right to deduct the interest you pay on your mortgage. This can get complicated,.
First, what qualifies for the deduction? 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 if you rent it out for more than 14 days or ten percent of the number of days during the year that the home is rented). And if your boat or motor home has a toilet, sleeping and cooking facilities, the interest you pay can also be deducted.
If your mortgage was dated before October 13, 1987, and you still pay 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 dollars. 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 loans, the IRS has allowed homeowners to deduct the interest up to the full $1,100,000, even if there is no separate home equity loan.
If you fall into the Alternative minimum tax category, talk with your financial advisors, because you will not be able to deduct over the $1 million threshhold.
Did you pay points? Look at your settlement statement – called the HUD-1. If there is a line item called loan origination fee, maximum loan charges, or loan discount, those are points. Typically, one point is the equivalent of one percent of the total loan, and lenders will usually lower your interest rate between 1/8 to 1/4 for every point you pay.
You cannot deduct these points in the year you pay them; you have to deduct them over the life of the loan. So if you paid $4000 in points to obtain a 30 year loan, you can deduct $133.33 each year (4000 ÷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 also to claim more of a deduction.
One additional benefit included in the January 1st legislation is that 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 as well as private mortgage insurance companies.
What about reverse mortgages? The moneys you receive – either by way of a lump sum or by periodic payments – is not considered income and thus 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 may be able to deduct a portion of the moneys. However, a reverse mortgage loan is generally subject to the $100,000 limitations on home equity debt. Once again, talk with your tax preparer for more details.
by Benny L. Kass