YOUR TAXES: A SPECIAL REPORT : OWNING A HOUSE : Some Rules Have Changed, but the Basics Are Still the Same

More than ever, home is where the tax deduction is.

But, as in nearly everything to do with taxes, deductions related to homeownership are not all the same anymore.

Very recent changes in the tax law could mean major disappointment to those refinancing their homes, and the rules can also get confusing when it comes to the “home equity loans” being promoted these days.

The basics remain the same. “The interest and the property taxes are your main deductions in connection with home ownership,” said William M. Ruddy, a partner in the Los Angeles office of the Ernst & Whinney accounting firm.

Interest paid on a home loan in 1987 is fully deductible as long as the loan balance does not exceed the cost of the residence plus improvements. Such interest payments are deductible only on a person’s principal home and one other house. Property taxes also are fully deductible.

When it comes to closing costs, some can be deducted and some cannot.

Home buyers can deduct the loan points they pay, a fee paid to the lender that usually runs between 1% and 3% of the loan amount. Additional loan origination fees also are deductible. For example, if a lender charges 2 points plus $250 on a $100,000 loan, that entire amount--$2,250--can be added to the buyer’s other itemized deductions for the year.

Any partial-year property taxes also are deductible for the buyer. That is, if the house is purchased on Dec. 1, the buyer pays the last month’s property taxes while the seller is responsible for the rest.

All the other closing costs, from the appraisal fee to the title insurance fee to the escrow charges, are not deductible. But they will be important for tax purposes when you sell your house. These costs plus the purchase price and any improvements you make all are part of what is called the “cost basis” of the house.

The cost basis of the house is important for determining your total gain when the house is sold.

“Anything you do to improve the house must be documented thoroughly,” said Joe Knott, a tax partner with Kenneth Leventhal & Co., a national accounting firm that specializes in real estate and financial services. “What we find is most taxpayers are very lax in their record keeping, so we tell them to keep a permanent file” for all home improvement receipts.

However, expenses associated with maintaining the house--routine painting or the monthly gardener’s bill, for example--are not considered home improvements and do not add to the cost basis of the house.

Although sales taxes no longer are deductible, sales taxes on home improvement items can be included in the cost basis of the house, Knott said.

One frequently overlooked exception under which a significant chunk of closing costs can be deducted is when the taxpayer buys or sells a house as part of a move that results from a job change, Ruddy said.

“Most of the things you see on the escrow statement would qualify, provided you meet the deductibility standards of moving expenses in general,” he said.

There are certain tests you must meet. The new job must be at least 35 miles farther from your old home than the old job was. And you must work full time for at least 39 weeks during the year after the move.

If you meet those tests, you may deduct such costs as title and escrow fees, sales commissions, state transfer taxes and advertising costs. But you cannot deduct costs to improve the house to help sell it or any charges for interest payments or prepayments.

A taxpayer can deduct a maximum of $3,000 in real estate expenses as part of moving expenses, which are accounted for on Form 3903 and attached to the basic Form 1040.

As for that old faithful deduction for mortgage interest, “you have to keep in mind that the mortgage interest deductions are changing again,” Knott said. That includes some complicated changes in rules for deducting interest for all loans secured by a home, including refinancing and home equity loans.

It used to be that debt secured by a house was deductible as long as the loan did not exceed the fair market value of the house. That meant that, on a newly purchased house, the interest was fully deductible. And on a refinanced loan, you could deduct interest on the amount of the loan up to the market value of the house.

But the rules changed for home loans secured after Aug. 17, 1986. Loans obtained since then are eligible for interest deductions only up to the purchase price of the home plus improvements. That means that when refinancing, you may not be able to deduct all of your interest payments.

Late last year, the law changed again, but most people will not be affected, Knott said. The most recent mutation, starting in 1988, limits the amount of indebtedness on a primary residence and a second home to a total of $1 million. “That’s a lot of debt,” he said.

The same law also changed the rules for the popular home equity loan, a second mortgage that consumers are using to pay off all sorts of debt now that the consumer interest deduction is being phased out.

Starting in 1988, a homeowner will be able to deduct interest payments on another $100,000 of home equity loans, in addition to the mortgage.

That home equity interest is deductible as long as the sum of all loans secured by the house does not exceed the fair market value of the house. That change could benefit people who found themselves bumping up against the old limitation that interest on combined home loans could not exceed the price of the home plus improvements.

Many people who purchased homes after Oct. 13, 1987, could get a shock when they try to refinance their residences, Knott said.

“As you pay down the mortgage, your acquisition debt amount decreases,” he said. “If you go to refinance, the amount is limited” to the balance of the old loan plus $100,000. Beyond that, the interest is not deductible.

For example, if you bought a $350,000 house after Oct. 13 and paid the mortgage loan down in the future to $50,000, any refinancing in excess of $150,000 is not deductible, even if you have equity of $300,000 in the house. What’s more, under the old rules, the homeowner could have taken out a home equity loan of $300,000 and deducted the interest because the total would not have exceeded his cost basis in the house. The new rules reduce that to an additional $100,000 starting in 1988.

“That’s a lot different than people are used to,” Knott said.

“People pay down and try to pull money out of their house all the time,” he said, adding that older people with large equities in their home would be particularly affected.

“That will change the way people view their home in terms of tax deduction,” Knott said. “I think people will probably be a little more liberal with respect to how much debt they’re willing to take on their personal residence. They might not be willing to pay it off as quickly.”

They also might opt for 30-year rather than 15-year mortgages, which have been gaining in popularity in recent years.

“The loss of tax benefits will be significant, particularly because interest rates are probably going to go up,” Knott said.