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UNCLE SAM HAS A LONG TRADITION of promoting home ownership. It’s no wonder that 67 percent of all households in the United States now own the homes they occupy. Subsidies and tax breaks for homeowners have become an American tradition and a political sacred cow that few politicians would dare challenge.
It helps that homeowners have the support of powerful trade organizations such as the National Association of Realtors, The Mortgage Bankers Association and the National Association of Home Builders.
But more important, federal policy makers realized some time ago that home ownership helps provide the foundation of social, economic and political stability necessary for a free society to function. For most people, their home is their largest lifetime investment. Homeowners have a strong incentive to seek gainful employment, maintain their property and participate in community affairs.
During the Westward Movement of the 1800s, federal land grants to homesteaders provided a major incentive for settling vast and often hostile territories. The tax deduction for home loan interest was granted in 1920 and has been firmly entrenched ever since. The Great Depression gave homeowners the amortized loan, the Federal Housing Administration and the secondary mortgage market (Fannie Mae and Freddie Mac). Returning World War II Veterans got the GI Bill, offering VA-guaranteed home loans with low or no down payments.
The latest windfall for homeowners is the 1997 Taxpayer Relief Act. This wipes out the provisions of the previous 1986 Tax Act which included the rollover replacement rule and the once-in-a-lifetime $125,000 capital gains exclusion. Some call it the Tax Accountant Relief Act, because you will probably need expert tax advice to understand and take full advantage of all the benefits.
Record-Keeping and Tax Advisors
As always, you need to keep good records to maximize your tax breaks and to defend them if necessary during a tax audit. The IRS can go back as far as 7 years looking for unreported income. If they suspect fraud, there is no time limit.
The following is a brief summary of the major tax breaks available to homeowners today. The tax laws are complicated, can change from time to time and are subject to different interpretations. Other types of tax strategies – tax-deferred exchanges, reverse mortgages, charitable donations and conservation easements – merit more thorough discussion. See your tax advisor for more detailed explanations. He or she can help you determine if and how these tax breaks apply to your individual circumstances.
The Six Types of Tax Breaks
There are six categories of tax breaks, listed below in descending order from the biggest breaks to the smallest.
- tax credits – subtracted directly from taxes due
- tax exclusions – the exclusion of gain or profit from being taxed
- tax deferrals – the ability to put off paying taxes until some future date
- current expense deductions – deductible from taxable income in the current year
- amortized expense deductions – tax deductions spread out over a number of years
- capitalized expenses – tax deductible expenses added to the base cost of the property
Buying a House
You can claim a current expense deduction for the interest buydown points you pay when taking out an original purchase loan, whether the points are paid by you or the seller. Each point is equal to one percentage point of the loan amount. You can also deduct prorated mortgage interest and property tax. Be sure to save the settlement statement from the title company which itemizes these expenses. Settlement costs are sometimes called closing or escrow costs.
Other settlement costs – transfer, recording and title fees, etc. – are not deductible in the current tax year. However, they can be added to the base cost of the property for a future tax break when the home is sold.
Home Improvements
Certain types of home improvements can add to the base cost of your home and reduce your capital gain (and potential tax obligation) when you sell. These include such things as replacing a roof or adding a room, which extend the useful life of the house or change or add to its use. You may save some money by doing the work yourself, but the IRS does not consider the value of your personal labor.
These are called capitalized expenses. They are the lowest category of tax breaks because they can’t be used until you sell your home. However, home improvement costs can add up over the years, so it’s important to keep these records in a separate file for future tax use.
There are no tax breaks for normal repair and maintenance such as painting and carpet replacement. However, if you upgrade your floor covering you can claim the difference in cost between the upgrade and a replacement as a home improvement.
Refinancing a House
With rising home prices, many homeowners now have substantial equity they can tap with a home equity loan. This is also called a second mortgage because the loan sits in second position behind the first mortgage. Homeowners can take the cash in a lump sum or get a home equity line of credit, which is like having a low-rate credit card with tax-deductible interest. Homeowners with outstanding credit card balances can benefit by paying them off with a home equity loan.
Unlike original purchase loans, the points for refinanced or second mortgages must be amortized over the life of the loan. If all or some of the new loan is used for home improvements, then all or some of the points can be deducted in the current tax year.
Casualty Loss
Uninsured losses from fires, floods, earthquakes, storm damage and theft are current expense deductions. Casualty losses must be “sudden, unexpected and unusual,” which excludes such things as termite damage and pipe corrosion. Only the casualty losses which exceed 10 percent of your adjusted gross income are deductible.
Good record-keeping is especially important in reporting any kind of casualty loss. An inventory of home contents along with exterior and interior photographs of the house should be kept in a safe deposit box or other secure offsite location.
Selling a House
The 1997 Tax Act gives homeowners a whopping $250,000 capital gains tax exclusion when they sell their house ($500,000 for married couples filing jointly). The new law applies to home sales which occur on or after May 7, 1997. The owners must have lived in the home as their principal residence for 2 of the 5 years ending in the sale, and must have also owned the home for 2 of these 5 years.
The 2 years of residency don’t have to be continuous, nor must they coincide with the 2 years of ownership. For example, you could rent the house for two years to satisfy the occupancy requirement, then buy the house and own it for the next two years to satisfy the ownership requirement. After the fifth year you would qualify for the exclusion.
The 1997 Tax Act replaces the previous 1986 tax law which allowed sellers to defer or “roll over” their capital gains if they bought a replacement home of equal or greater value. The 1986 law also gave a $125,000 once-in-a-lifetime tax break for homeowners over age 55. The new law gives homeowners a much bigger tax break, does not impose an age limit, and allows them to take the $250,000 or $500,000 tax exclusion every two years.
Empty-nesters now have the opportunity to sell their house and downsize to a smaller home, pocketing their profits tax-free for future retirement. Some entrepreneurs see opportunities for “serial homesteading,” moving from one house to another and accumulating the tax-free profit from each sale.
The new tax law has a number of provisions for home sellers who can’t meet the occupancy or ownership requirements due to health problems, employment changes, divorce or the death of a spouse. However, if you sell your house at a loss you’re still out of luck. So far, there are no tax breaks for home sale losses.
In general, the gain from a home sale is the sale price minus the adjusted base cost of the home. The adjusted base cost is generally the original price you paid for it plus the home improvements you made over the years you owned it.
Home Offices
The IRS has finally accepted the fact that over 25 million Americans really do work at home. Effective January 1, 1999, the 1997 Tax Act expands the tax breaks for the business use of a home. Homeowners can deduct a portion of their utilities, home insurance, property taxes, mortgage interest and home repairs as business expenses. Those who work at home can even get a tax break for depreciation on the business portion of their home.
The business portion of the home must be used “regularly and exclusively” for business. It must be either a principal place of business; a place where the homeowner meets patients, clients or customers; or a separate unattached structure. The homeowner can even be an employee and qualify for the tax breaks.
Ongoing Homeowner Tax Breaks
The annual mortgage interest deduction is the largest single tax break in the tax code, saving homeowners tens of billions of dollars every year. This massive federal subsidy makes home ownership possible for millions of households that might not otherwise be able to afford it. The mortgage interest deduction was the only homeowner tax break from 1920 to 1950. The property tax deduction was granted in 1951.
Homeowners can deduct their annual property taxes and some types of annual assessments levied by special districts and common interest developments. In some cases, homeowners on leased land can deduct their lot rent.
Second Homes and Vacation Homes
Homeowners can deduct mortgage interest and property taxes from second homes and vacation homes as long as they are rented for 14 days or less per year. They can also pocket the rent tax-free. Beyond this 14-day limit the IRS considers the home to be income property, which is regulated by different tax rules.
When income property is sold, there is no capital gains exclusion like there is for owner-occupied homes. Sellers either have to pay the capital gains tax or conduct a tax-deferred exchange for other income-producing real estate of equal or greater value. For income property, mortgage interest, property taxes and other expenses must be deducted against the income the property produces.
Some creative tax avoiders convert their rental property into a principal residence by moving into it for a year or so (the exact time requirement has not been established), making it eligible for the $250,000 or $500,000 residential tax exclusion when sold. Others qualify their second home as a principal residence by living in it 2 out of the 5 years preceding a sale.
Moving Costs
Homeowners may qualify for a residential moving cost deduction if the new job site is 50 miles or more farther away from their old home than the old job site. This applies to the self-employed as well as to employees. It also applies to those who work at home.
Employees have to work at least 75 percent (39 weeks) of the next year at or near the new job site. The self-employed must work at least 75 percent (78 weeks) of the next two years at or near the new job site.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
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Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor“ and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
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