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chapter focuses on a series of tax issues related to your residence or vacation home. We
start with a discussion of personal and residential interest, continue with other issues
connected to the ongoing ownership of a home, and conclude with a discussion of issues
arising at the time of sale and possible replacement purchase.
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For many families, a personal residence is the largest single investment they will
make. There are many tax advantages to owning a home, the deductibility of mortgage
interest being a primary one. The tax law places substantial limits on tax deductions for
interest expenses other than deductions for home mortgage interest. Thus, mortgages on
residences and vacation homes are often the sole tax-effective way for individuals to
borrow. This may affect how you finance everything from a car to a college education.
Four Categories of Interest Expense
For tax purposes, there are four categories of interest expense, each of which is
subject to different rules for determining the amount that can be deducted:
- Personal
- Qualified residence
- Trade or business (including passive)
- Investment
With few exceptions, the purpose for which borrowed funds are used generally determines
the category into which the related interest expense will fall. Trade or business interest
expense generally is fully deductible against the related trade or business income (but
see Chapter 12 on passive activity loss rules).
Investment interest expense limitations are discussed in Chapter
9. Here we will focus on the other two types.
- Personal Interest: Personal (or consumer)
interest is generated by any debt that is not qualified residence debt, trade or business
debt (active or passive), or investment debt. Interest on automobile loans, credit card
balances, education loans, tax deficiencies, and the like is considered to be personal
interest. Personal interest is not deductible.
- Residence Interest: Generally, residence
interest expense is deductible if specified debt limits are observed. Residence interest
expense is generated on debt secured by the taxpayer’s principal or second residence.
The principal residence is usually the residence in which the taxpayer lives. A second
residence may be another dwelling that provides basic living accommodations. The law
defines two types of residence interest: acquisition indebtedness and home equity
indebtedness. The interest expense related to these two types of debt is collectively
referred to as qualified residence interest.
- Acquisition Indebtedness. Acquisition indebtedness is incurred to buy,
build, or substantially improve a principal or second residence. Interest expense on up to
$1 million acquisition debt is deductible. In most cases, acquisition debt consists of the
original purchase money mortgage. In addition, the IRS may allow mortgage debt incurred
within ninety days of expenditures to acquire a principal or second residence to qualify
as acquisition indebtedness. The only other way to increase acquisition debt is to borrow
additional amounts to make improvements to the residence.
A refinanced mortgage is considered to be acquisition debt only to the extent of the
unpaid balance of the acquisition debt that existed immediately before the refinancing.
Refinancing proceeds in excess of that amount do not qualify as acquisition debt. They are
considered to be either home equity debt or debt subject to the rules characterizing
interest expense on the basis of the use of the borrowed funds.
An exception is made for home mortgage debt outstanding on or before October 13, 1987. All
such debt, including second mortgages and refinancing before that date, is considered to
be acquisition debt. In addition, the $1 mil-lion debt limit does not apply. Thus,
interest expense on this debt continues to be fully deductible. However, the amount of
such debt reduces the amount of the $1 million available for new acquisition debt. For
refinancings of this debt that occur after October 13, 1987, there are additional
restrictions besides those discussed above. These restrictions limit the period for which
interest expense on refinanced debt may continue to qualify for deduction under the
special provision.
Mortgage delinquency charges as a result of late installment payments are not considered
deductible interest.
- Home Equity Indebtedness. Home equity indebtedness consists of
borrowings secured by a residence over and above the taxpayer’s acquisition debt. Tax
law cannot limit the amount of debt secured by your residence, but for tax purposes the
technical definition of home equity indebtedness is met only by the lesser of (1) the fair
market value of the residence reduced by the amount of acquisition indebtedness or (2)
$100,000 of that debt. For amounts up to this limit, the related interest expense is fully
deductible, usually without regard to how the borrowing funds are used, with the exception
of tax-exempt investments. To the extent that home equity borrowing exceeds the limit, the
related interest is subject to the general rules that look to the use of the borrowed
funds to determine the character of the interest expense.
- Points Paid on Mortgages. Points are the charges paid by a borrower to
a lender as loan origination fees, maximum loan charges, or premium charges. Generally,
each point that you pay will reduce the stated interest rate on a thirty-year mortgage by
between one-eighth and one-quarter of one percentage point. If, however, you pay off the
loan early, the effective interest rate may turn out to have been higher than if you had
paid a higher interest rate and fewer points.
In general, the payment of points must be spread out and deducted over the life of the
mortgage. However, there is an exception. You may fully deduct the points that represent
interest that you pay in the year you pay them if (1) you itemize deductions; (2) your
loan is used to buy or improve your main home and is secured by your main home (if you own
more than one home, your main home is the home you live in most of the time); (3) your
loan meets the requirements for deductible mortgage interest; (4) paying points is an
established business practice in the area in which the loan was made; (5) the points you
paid were not more than the points generally charged in the area; and (6) you paid the
points with funds other than those received from the lender.
To fully deduct points used to buy your main home, you must also provide funds at the time
of closing that are at least equal to the points charged. Funds you provide may include
the down payment, escrow deposits, earnest money applied at the closing, and other funds
actually paid at closing.
Points paid for specific services that the lender performs in connection with your account
are not interest and are not deductible, but may increase your basis (see
"Basis" below). The deductibility of noninterest-related amounts incurred in
connection with buying or selling a home and their effect on your gain or loss with
respect to the residence are discussed later in this chapter.
- Refinancing: Deducting Points: What becomes of points paid on your
original mortgage when you refinance? Since the original mortgage is canceled when you
refinance, the balance of points paid in connection with it, but not yet deducted, can be
deducted in the year of the refinancing. Points paid in connection with the refinancing
would be amortizable and deductible only over the term of the new mortgage. However, there
may be an exception. A 1990 court case appears to support the current deduction of points
incurred in refinancing a short-term balloon payment mortgage.
Also, the result is different if you "pay" the points on your original mortgage
by adding them into your new mortgage loan. In that case, are the points from the original
mortgage deductible in the year of the refinancing, or are they deductible ratably over
the life of the refinancing? In effect, you have a choice: you can borrow (1) from Peter
to pay Paul and get an immediate deduction, or (2) from Peter to repay Peter and defer and
amortize the deduction. That is, you are allowed an immediate deduction for the
unamortized balance of the points paid on the first mortgage if you do not use the same
lender for the refinancing. If the refinancing is done with the same lender, the deduction
should probably be spread over the term of the new loan.
New Debt: Your Options
The following guidelines can help you to determine the most tax-efficient means of
incurring new debt or restructuring existing debt. In all cases of financing major
household expenditures, the after-tax cost of available financing sources should be an
important consideration.
- Home Improvements: Separate identifiable mortgage
financing of home improvements qualifies as acquisition indebtedness. This should result
in fully deductible interest and does not reduce the fair market value or the $100,000 tax
limit for home equity debt, which may be reserved for another purpose. A second choice for
financing home improvements is home equity debt. But see the caution below.
- Consumer Purchases: Home equity debt can be
considered for financing consumer purchases. It offers fully deductible interest expense
-- a feature that is not shared by traditional installment debt. But see the caution
below.
- Existing Consumer Debt: If you face the prospect
of no tax deduction for interest on existing consumer borrowings, you may want to consider
refinancing them with home equity debt. Use caution when deciding to use home equity debt
to pay for consumer purchases or existing debt, as the loan is backed by what is perhaps
your most important investment—your home. If you fail to make the scheduled payments,
you could lose your home, not just the assets you purchased with the borrowed money.
Other Tax Issues in Owning a Home
- Home Office: If you use part of your home for
business purposes, you may be able to qualify for home office deductions. You must be able
to prove that the office at home is used "exclusively" and on a
"regular" basis as a "principal" place of business or as a place for
patients, clients, or customers to meet or deal with you in the normal course of your
trade or business. Deductions for a home office are limited to the excess of gross income
from the business activity reduced by (1) home mortgage interest and taxes allocable to
the business activity and (2) all other deductible expenses of the business activity
unrelated to the use of the home office unit itself. Any disallowed deductions can be
carried over to future years, subject to the same gross income limitation in the
subsequent years. Home office deductions (other than mortgage interest and property taxes)
are disallowed when an employee is reimbursed by an employer (paid rent) for the use of
the home office.
Expenses for business use of the home are shown on Form 8829. This form takes into account
the limit described above and also includes a series of questions that will help determine
the appropriate business percentage for the area of your home used as an office. The
instructions suggest that you use square footage, number of rooms, or any other reasonable
method.
- Vacation Home: A vacation home can be a house,
apartment, condominium, house trailer, boat, or similar property. Taxpayers often rent
vacation homes to third parties.
If you do not personally use your vacation home, there are no special limits on the
deduction you may claim from owning and renting the residence to others (other than the
passive loss and other limitations placed on all rental real estate activities, as
discussed in Chapter 12). Personal use is deemed to
occur when the taxpayer uses the property for personal purposes for more than the greater
of (1) 14 days or (2) 10% of the number of days the property is rented at a fair market
rental. Personal use generally includes the use of the facility by the taxpayer or family
members.
If you do use the property for personal purposes, the following rules apply:
- If the unit is rented for less than 15 days during the tax year, the gross income is
excludable and no deductions (other than interest and taxes attributable to the residence)
are allowed. Congress has recently considered repealing this rule.
If the unit is rented for 15 days or more during the tax year, deductions attributable to
the residence (including interest and taxes) are allocated between rental use and personal
use. The taxpayer will be allowed deductions attributable to the rental use in an amount
up to the gross rental income (but not in excess of the gross rental income). Deductions
attributable to the rental use that are limited by the vacation home rules may be carried
over and used to offset future gross rental income.
Buying and Selling Your Home
If you decide to sell your home, you face two sets of tax issues. First, you will need
to address the possibility of recognizing taxable gain at the time of sale. Specific rules
allow you to reinvest and defer the gain or, if you are over 55, to exclude part of the
gain. Second, you will not want to lose any available deductions or additions to the tax
basis of your home through either poor recordkeeping or poor planning.
If you were to sell your home and not reinvest the proceeds as described below, you
would have to recognize any gain on the sale. Generally, the gain would be the excess of
what you received for the home over your tax basis in it. If you realize a loss on the
sale of a principal residence, you receive no tax benefit. The loss is a nondeductible
personal loss.
- Proceeds from the Sale: For purposes of
computing your gain on the sale of your home, your proceeds are the amount paid by the
buyer less amounts you incur in the sales transaction. Thus, proceeds are reduced by
agent’s commissions, other selling expenses (such as advertising and legal fees), and
certain loan charges that you pay for the buyer. Note that the proceeds that are used to
pay off your mortgage count as proceeds from the sale in computing your gain.
- Basis: Your basis in your home usually is the
amount you paid for the home, including your down payment and any debt you incurred or
assumed, such as a first or second mortgage. If you contracted to have your home built on
land that you own, your basis in the home is your basis in the land plus the amount you
paid to have the home completed, including the cost of labor and materials, the amount you
paid the contractor, any architect’s fees, building permit charges, utility meter and
connection charges, and legal fees that are directly connected with building your home. If
you built all or part of your home yourself, you cannot include the value of your own
labor or any other labor for which you did not pay.
If you did not purchase your home, special rules apply. For example, if you received your
home as a gift or in the process of divorce, your basis for determining gain will be that
of the prior owner. If you received your home
as compensation, your basis will be the fair market value when you received it. If the
home came to you as an inheritance, your basis will be determined by the value of the home
in the estate.
- Settlement or Closing Costs Added to Your Basis. The following items
charged to you as the buyer at settlement or closing cannot be deducted but should be
added to the cost of the home and become part of your original basis (and reduce your gain
on the eventual sale of this property): attorney’s fees; abstract fees; charges for
installing utility services; transfer and stamp taxes; surveys; title insurance; and
unreimbursed amounts you pay that the seller owes (such as back taxes or interest,
recording or mortgage fees, charges for improvements or repairs, or selling commissions).
Note that if the seller actually paid for any item for which you were liable and which you
could deduct if you had paid it, such as your share of the real estate taxes for that year
(discussed later in this chapter), you must reduce your basis in the home by that amount
unless you were charged for it in the settlement (that is, you reimbursed the seller for
it).
- Adjusted Basis. While you own property, events may occur that may
increase or decrease your original basis in the property. The result is your adjusted
basis. Increases to basis include capital expenses, such as improvements and additions;
special assessments for local improvements; and amounts spent to restore damaged property.
Decreases to your basis include insurance reimbursements for casualty losses; deductible
casualty losses not covered by insurance; payments received for an easement or
right-of-way granted; depreciation deductions if you used your home for business or rental
purposes; and gains from sales of old residences on which tax was postponed.
- Deferring or Excluding Gain: Although a gain
realized on the sale or exchange of your residence may result in taxable income, you may
be able either to defer this gain by reinvesting the sales proceeds or, if you are over
fifty-five, to elect to exclude it.
A gain realized on a sale or exchange of a principal residence may be deferred if you
invest the proceeds by buying or building another principal residence within a time period
beginning two years before the date of the sale and ending two years after the sale date.
(There is a limited exception for members of the Armed Forces.) If you are planning to
sell your residence next year, consider using the home solely for personal purposes and
discontinuing any business or rental use of your home. Otherwise, you may be required to
recognize part of the gain.
For you to defer the full amount of the gain, the cost of the new residence must be at
least equal to the adjusted sales price of the old residence. If it is not, a gain is
recognized to the extent that the adjusted sales price of the old residence exceeds the
cost of the new residence. Sales expenses and fixing-up expenses may be deducted from the
sales contract price in determining the adjusted sales price. Sales expenses include
broker’s fees, fees for drafting a contract or deed, escrow fees, and mortgage title
insurance. Fixing-up expenses include decorating and repair expenses incurred to sell the
old home. They must be paid within thirty days after the sale date and be for work
performed within ninety days before the signing of the sales contract.
For taxpayers who are 55 years of age or older, a once-in-a-lifetime election is available
to exclude from gross income up to $125,000 of any gain recognized on the sale or exchange
of a principal residence. The property must be owned and used by the taxpayer as his or
her principal residence for at least three of the five years preceding the date of the
sale (with an exception for tax-payers who become incapable of self care). The years of
ownership and the years of use don’t have to run simultaneously.
Issues at Settlement on a Personal Residence
- Settlement and Closing Costs: When you
purchase a personal residence, you may be able to deduct other items (in addition to the
qualified residence interest discussed above). As discussed earlier in this chapter, other
items may be added to your basis in the home and decrease the gain when you eventually
sell it. You should keep the settlement sheet for your records.
- Real Property Taxes: Real property tax is usually
divided so that the buyer and seller each pay tax for the part of the property tax year
that each owned the home. For federal income tax purposes, the seller is deemed to pay the
property taxes up to, but not including, the date of sale, and the buyer is deemed to pay
the taxes beginning with the date of sale, regardless of the property tax accrual or lien
dates under local law. Even though the entire amount is paid by either the buyer or the
seller, for tax purposes the buyer and seller are each considered to have paid his or her
own share of the tax and may deduct his or her own share as an itemized deduction for the
year the property is sold. So, if at settlement, you (as buyer) pay real estate taxes for
a portion of the year that "belongs to" the seller (that is, taxes up to the
date of sale), you may not deduct those taxes but may add the nondeductible amount to the
basis in the home. If the seller pays the full amount of taxes, you (as buyer) may still
deduct the taxes beginning with the date of sale. If you did not reimburse the seller for
your portion of the taxes
he or she paid, you must reduce your basis in the home by the amount of your share of the
taxes.
- Other Expenses of Sales: Some settlement costs
that you cannot deduct or add to your basis include fire insurance premiums, FHA mortgage
insurance premiums, points paid on a VA loan or for other specific lender services,
charges for using utilities, rent for occupying the home before closing, and other fees or
charges for services concerning occupying the home.
- Note to Buyers: In a soft market, the seller can
often be convinced to pay points for the buyer. If you are the buyer, word your contract
so that, to the extent possible, the seller’s points pay nondeductible closing costs
such as fees for appraisal, surveys, title insurance, or recording title costs instead of
points you could otherwise deduct as interest. But remember, lenders typically will not
allow the seller to pay prepaid items such as interest, taxes, and insurance escrows.
Conclusion
Given the substantial limits on tax deductions for interest expenses, borrowing against
your residence or vacation home may be the sole tax-effective way to borrow. There are
many complex rules related to qualified residence interest and financial matters
surrounding the buying or selling of a home. Your tax and financial adviser should be
consulted on these matters in relation to your particular plans and circumstances. |
