By: Martin M. Shenkman, CPA, MBA, JD
For many senior citizens, their home mortgages have generally been satisfied, or reduced to modest levels, such that the deduction for home mortgage interest is not a significant planning consideration. For some seniors, however, it may be. This might occur, for example, if the clients cannot generate sufficient cash flow necessary to fund their living expenses. In such cases, the seniors may use home equity lines or finance (or refinance) their homes to fund expenses. In these cases, the home mortgage interest rules become important. For many homeowners in New Jersey, property tax rates are relatively high, so the deduction for these taxes can be important. The following discussion provides a brief overview of these rules.
Mortgage Interest Deduction To deduct mortgage interest, the home must be a “qualified home” for purposes of the home mortgage interest rules. A qualified home includes a house, condominium, cooperative apartment (see below), mobile home, boat or similar property that provides basic living accommodations, including sleeping space and toilet and cooking facilities. It does not include any portion of the home used for nonresidential purposes (home office or rental). Both principal residence and one second home designated by the client can qualify. For a second home to qualify, the client or his family must use it for personal purposes for the greater of either 14 days or 10 percent of the number of days it is rented at a fair rental value.
Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving a qualified residence, and which is secured by the residence. Further, the principal balance cannot exceed $1 million. Home improvements are items that add to the value of the client’s home, prolong its useful life, or adapt it to new uses. The value of the time the client spends fixing or renovating his home cannot be included. Repairs that maintain the client’s home in good condition, such as repainting, are not home improvements. Items that may be included might be insulation, a new hot water heater, new roof, swimming pool, and so forth. The key to resolving these types of issues on most IRS audits is often just good record keeping.
In addition to the acquisition indebtedness discussed above, individuals are allowed to take out an additional amount of debt up to $100,000 and deduct the interest on it. This debt must be secured by a lien on the residence. This debt is called home equity indebtedness. This home equity debt can be used for any purpose. Thus, home equity indebtedness is debt, other than acquisition indebtedness, which is secured by the client’s residence. It cannot exceed $100,000 (or the fair market value of the client’s home less acquisition indebtedness).
The loan must be secured by the client’s residence to satisfy the home mortgage interest deduction rules. Practitioners should be especially alert for intra-family loans that are not documented.
Deducting Home Mortgage Insurance Premiums If a client pays premiums for mortgage insurance during 2007-10, for mortgage insurance issued after 1/1/07, the payments are treated as mortgage interest, deductible to the extent your client can deduct mortgage interest. IRC Sec. 163(h)(3)(E). Premiums properly allocable to periods after December 31, 2010 are not covered by this provision. In effect, these amounts paid for qualified mortgage insurance premiums are treated as a separate category of qualified residence interest. Any prepayments of qualified mortgage insurance premiums must be written off (amortized) over the shorter of the term of the loan, or 84 months. IRS Notice 2008-15. This benefit is phased out for taxpayers whose adjusted gross income exceeds $100,000 and is completely eliminated if your income (AGI) exceeds $109,000.
Property Tax Deduction Property taxes (county, city, and other real estate taxes) can be one of the largest expenses for a homeowner. Fortunately, for many homeowners these payments are deductible for income tax purposes so that tax savings may offset part of the cost. Determining how much property tax the client can deduct is not always a simple matter, as explained below. Deducting property taxes can be an important advantage of home ownership. Tenants generally pay for property taxes indirectly through the rent payments they make to their landlords. Tenants, however, cannot deduct property taxes.
Additional complications arise when the client buys or sells a house (e.g., taxes allocated on the RESPA must be considered).
Once the client has passed the various tax law restrictions and requirements, property taxes will generally be tax deductible. However, as with most tax rules, the laws become quite complex, with a host of special rules and exceptions. For example, if the client is charged with special assessments, the amounts paid may have to be added to the client’s tax basis in the home, rather than be deducted.
Need to Itemize Tax Deductions To obtain some of the major income tax benefits of home ownership — deducting mortgage interest and property taxes — the client must itemize deductions on his or her federal income tax return. If the client cannot, no deduction will be available. The standard deduction, to which every taxpayer is entitled without itemizing effectively sets a threshold. Unless total deductions exceed this threshold amount, there will be no tax benefit to property tax or home mortgage interest and property tax deductions. Even if the threshold amounts are exceeded other tax restrictions might still serve to reduce or eliminate any tax benefit.
For 2009, the standard deduction is $11,400 for married couples filing a joint return, $5,700 for singles and married individuals filing separately and $8,350 for heads of household. If the client’s total itemized deductions, including property taxes, mortgage interest, medical, charitable contributions, etc. do not exceed this amount, there may not be a tax deduction for mortgage interest or property taxes.
If the client is subject to the phase out of itemized deductions, which is triggered at certain higher income tax brackets, the deduction may be reduced considerably.In 2009, the phase out begins at $166,800 of income for married–filing-joint taxpayers. This phase out was scheduled to be eliminated in stages from 2006 until 2009. IRC Sec. 68. Phase outs of this nature affecting wealthy taxpayers may well be expanded under future tax legislation.Thus, the safest course of action for attorneys assisting clients in planning for residential real estate transactions is to have the tax issues coordinated, projections prepared, and the results confirmed, with the client’s accountant. This is especially important as the likelihood of changes to these rules occurring in the future is significant.
The Housing Assistance Tax Act of 2008 provided a limited deduction for state and local real property taxes for taxpayers who do not itemize deductions for 2008 only (although this might be affected by future changes). This limited change permitted non-itemizers to increase their standard deduction by the lesser of actual taxes paid or $1,000 for married taxpayers filing joint returns ($500 for others).
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