Your changing
tax life: Owning a home By Kay
Bell • Bankrate.com
Congratulations, you're about to take another
step up the American-dream ladder and become a homeowner. Along with
the joy of painting, plumbing and yard work, you'll now have some
new tax considerations.
The good news is that you'll be able to deduct many home-related expenses.
These tax breaks are available for any abode -- mobile home, single-family
residence, townhouse, condominium or cooperative apartment.
The bad news is that to take full tax advantage of
your home, your taxes will get more complicated. You're not living
on "EZ" Street anymore; you've moved to the 1040 long
form and Schedule A, where you'll have to itemize
deductions.
For many homeowners, the effort of itemizing is well
worth it at tax time. Some, however, might find that claiming the
standard deduction remains their best move. How do you decide? First,
find your standard deduction amount, based on your filing status:
$4,750 for single or married filing separately taxpayers; $7,000
for heads of households; and $9,500 for married couples who file
joint returns. Then compare it to the total expenses you can itemize
and file using the method that gives you the larger deduction.
Here's a look at homeowner expenses you'll be
to able to deduct (maybe enough to make itemizing worthwhile), ones
you can't and some tips to get the most tax advantages out of your
new property owning status.
Mortgage interest
Your biggest tax break will be reflected in the house payment you
make each month since, for most homeowners, the bulk of that check
goes toward interest. And all that interest is deductible, unless
your loan is more than $1 million. If you're the proud owner of
a multimillion-dollar mortgaged mansion, the Internal Revenue Service
will limit your deductible interest.
Interest tax breaks won't end with your home's first
mortgage. In the future you may decide to take advantage of low
rates and your real estate's growing value to pull
out extra cash through refinancing. Or you might decide instead
to get a home
equity loan or line of credit. Either way, that interest also
will be deductible, again within IRS guidelines.
Generally, equity debts of $100,000 or less are fully
deductible. But even then, the remaining amount of your first mortgage
could restrict your tax break. This could be a concern if you excessively
leverage your rapidly appreciating house.
When a homeowner takes out an equity loan that, when
combined with his first mortgage amount, increases the debt on the
house to an amount more than the property's actual value, the homeowner
faces additional deductibility limits. In these cases, the IRS says
you can deduct the smaller of interest on a $100,000 loan or your
home's value less the amount of your existing mortgage.
For example, you buy your home with a minimal
down payment. Three years down the road your mortgage balance
is $95,000 and the house is then worth $110,000. Your bank then
says you qualify for a 125 percent loan-to-value equity line, or
$42,500 ($110,000 x 125 percent = $137,000 - $95,000 left on your
first mortgage). To pay for your daughter's college tuition and
buy her a car to get to school, you take the bank up on the offer,
thinking the interest deduction on the loan would be icing on the
tax-break cake.
However, you're not going to get to deduct all that
interest. Instead, your deduction is limited to interest on just
$15,000 of the loan; that's the amount your home's value will exceed
your first mortgage. Interest payments on the other $27,500 will
not be deductible, even though the equity line is secured by your
home. So don't automatically assume you'll be able to deduct all
interest on home equity debts.
What if your real estate circumstances are a bit brighter?
Say, for instance, you're able to swing a vacation home on the lake.
You're in tax luck. Mortgage interest on second homes is fully deductible.
In fact, your additional property doesn't have to strictly be a
house. It could be a boat or RV, as long as it has cooking, sleeping
and bathroom facilities. You can even rent out your second property
for part of the year and still take full advantage of the mortgage
interest deduction as long as you also spend some time there.
But be careful. If you don't vacation at least 14
days at your second property, or more than 10 percent of the number
of days that you do rent it out (whichever is longer), the IRS could
consider the place a residential rental property and axe your interest
deduction.
Points
Will you pay points to get a better rate on any
of your various home loans? They offer a tax break, too. The only
issue is exactly when you'll get to claim it.
The IRS lets you deduct points in the year you paid them if, among
other things, the loan is to purchase or build your main home, payment
of points is an established business practice in your area and the
points were within the usual range.
A homeowner who pays points on a refinanced loan also
is eligible for this tax break, but in most cases the points must
be deducted over the life of the loan. So if you pay $2,000 in points
to refinance your mortgage for 30 years, you can deduct $5.56 per
monthly payment, or a total of $66.72 if you made 12 payments in
one year on the new loan.
But if the refinancing frees up cash you then use to improve your
house, you can fully deduct points on that money in the year you paid
the points. The same rule applies to home equity loans or lines of
credit. When the loan money is used for work on the house securing
the loan, the points are deductible in the year the loan is taken
out. If you use the extra cash for something else, such as buying
a car, you still can deduct the points but not completely on one tax
return. The points deductions must be parceled out over the equity
loan's term.
And points paid on a loan secured by a second home
or vacation residence, regardless of how the cash is used, must
be amortized over the life of the loan.
Taxes
The other major deduction in connection with your future home is
property taxes.
A big part of most monthly loan payments is
taxes, which go into an escrow account for payment once a year.
This amount should be included on the annual statement you'll get
from your mortgager, along with your loan interest information.
These taxes will be an annual deduction as long as you own your
home.
But as this will be your first tax year in your
house, scan the settlement sheet you'll get at closing to find additional
tax payment data. When the property is transferred from the seller
to you, the year's tax payments are divided so that each of you
pay the taxes for that portion of the tax year during which you'll
own the home. Your share of these taxes is fully deductible.
A word of caution: If your settlement statement shows
any money you'll pay into an escrow account for future taxes, this
amount is not deductible. You can only deduct the taxes in the year
your lender actually pays them to the property tax collector.
For example, you buy your house on July 1. Your property
taxes are due each Jan. 1. When you close, the seller had already
paid the year's taxes of $1,000 in full so you'll reimburse the
seller half of his annual tax payment to cover your ownership of
the property for the last six months of the year. Your $500 reimbursement
to the seller will be shown on your settlement documents.
The closing document will also show you pre-paid another
$500 to the lender as escrow for the coming year's taxes due next
Jan. 1. The $500 you'll reimburse the seller at closing is deductible
on this year's tax return, but the $500 held in escrow is not deductible
until it is paid the next year.
When you sell
When you decide to move up to a bigger home,
you'll be able to avoid some taxes on the profit you make.
Years ago, to avoid paying tax on the sale of a residence
a homeowner had to use the sale proceeds to buy another house. In
1997, the law was changed so that up to $250,000 in sales gain ($500,000
for married joint filers) is tax free as long as the homeowner owned
the property for two years and lived in it for two of the five years
before the sale.
If you sell before meeting the ownership and residency requirements,
you owe tax on any profit. The IRS provides some tax relief if the
sale is because of a change in the owner's health, employment or
unforeseen circumstances. In these cases, the tax-free gain amount
is prorated.
And a ruling by the IRS in late 2002 could put more
dollars in homeowners' pockets when they must sell before they qualify
for the full tax break. The Treasury has defined the unforeseen
circumstances that often force homeowners to sell and under which
they now can get some tax relief. They include:
- Death
- Divorce or legal separation
- Job loss that qualifies for unemployment
compensation
- Employment changes that make it difficult
for the homeowner to meet mortgage and basic living expenses,
and
- Multiple births from the same pregnancy.
A partial exclusion can be claimed if the sale was
prompted by residential damage from a natural or man-made disaster
or the property was "involuntarily converted," for example,
taken by a local government under eminent domain law.
What's not deductible
While many tax breaks are available to a homeowner, don't get too
carried away. There are still a few things for which you have to
bear the full cost.
One such expense is insurance. If you pay private mortgage insurance
because you weren't able to come up with a large enough down payment,
that's a cost you can't write off at tax time. Neither can you deduct
your property insurance premiums, even though the coverage generally
is required as part of the home loan and is included as a portion
of your monthly payment.
Other nondeductible residential expenses include homeowner
association dues, any additional principal payments you make, depreciation
of your home, general closing costs and local assessments to increase
the value of your neighborhood, such as construction of new sidewalks
or utility connections.
What about all those repairs that seem to crop up
the day after you move in? Surely they're tax deductible. Sorry.
While they'll make your house much more comfortable, you're on your
own here, too.
But hold onto the receipts. In today's hot real estate
market, some homeowners may find their property will appreciate
beyond the $250,000 ($500,000 for married couples) amount the IRS
will let you keep tax free when you sell. If that happens, the records
of
property improvements could help you establish a higher basis
for your house and reduce your taxable profit.
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