YOUR TAXES : Taxes Can Be Your Friend : Home Sweet Home : A residence is no longer just shelter from the cold and the tax man--now it’s a key component of financial planning.
It’s no secret that the Tax Reform Act of 1986 made homeownership one of the last great tax shelters. The landmark overhaul of the nation’s tax codes preserved deductions for mortgage-interest payments but reduced or eliminated writeoffs for most other types of investments.
But at the same time, the sanctity of housing-related tax breaks--coupled with fast-rising home values in California and many other parts of the country--has made owning a home more than just a shelter from the cold and the tax collector.
Now, experts say, it must also be viewed as a key component of your overall financial game plan.
“Owning a home is one of the last tax shelters available to most investors, but it’s also one of the most expensive,” said Martin M. Shenkman, a New York tax attorney and author of several real estate books. “So, you’ve got to know how to squeeze every last bit of writeoffs out of it and then use your equity to help you achieve your other financial goals.”
Under the tax codes, you can deduct interest on up to $1 million in combined debt used to build or buy a first and second home. You can also deduct the property taxes you pay, as well as a handful of certain charges you incur when setting up the loan.
Since deductions for interest payments on credit cards and most other types of non-mortgage debt are being phased out--only 20% of that interest will be deductible on your 1989 tax return--many experts today say most taxpayers should borrow as much as possible against their home and as little as possible to purchase other items.
That’s a turnaround from the philosophy of just a few years ago, when many experts advised taking out 15-year mortgages or making relatively large down payments to sharply reduce interest costs over the life of the loan.
“Of course, you can’t let the tail wag the dog,” said Thomas B. Gau, partner in the Torrance-based financial planning firm Kavesh & Gau. “If you take on a big mortgage just so you can get a lot of writeoffs, you might wind up putting too much strain on your monthly budget.”
If you already own your own home, there’s a good chance that fast-rising home values over the past few years have helped you build up tens of thousands of dollars in equity. A home equity loan can let you tap that reserve for even more writeoffs and, at the same time, provide you with cash to make other investments.
Most homeowners can deduct interest charges on up to $100,000 of home equity borrowing, regardless of how the money is spent. If you’re single or are married but file separately, the limit is $50,000.
If a home equity loan sounds enticing, proceed with caution. “Don’t fall for those advertisements that tempt you to take out a home equity loan to pay for a Caribbean cruise or a mink coat,” said Lawrence A. Krause, president of a San Francisco-based financial planning firm that bears his name. “Only take one out if you’re going to use the money for serious purposes--like financing a college education, remodeling your home, starting your own business or helping your kids buy their first home.”
You might also want to take out a home equity loan and use the proceeds to pay off high-interest credit card balances and auto loans. By shifting that debt to your mortgage, you’ll side-step the phase-out of writeoffs for non-mortgage debt and retain the ability to deduct all your interest charges.
“Generally, the more money you owe on credit cards and the like, the more sense it makes to take out a home equity loan and pay off that non-mortgage debt,” said financial planner Gau. “If you just have a few thousand dollars in debt, shifting it to your mortgage probably won’t be worth it--the fees involved in setting up the home equity loan up will probably wipe out all of your tax savings.”
When you sell your home, you’ll be able to defer paying taxes on your resale profit, if you buy a home of equal or greater value. If you have built up a lot of equity, balancing your need for mortgage-interest deductions against your other investment objectives will help you figure out how large of a down payment you should make on the new house.
“If you’re in your 30s or 40s and have plenty of other investments, you can go ahead and make a 20% of 30% down payment on the new home,” said Krause.
“But if you don’t have much in the way of other investments, think about putting just 10% down and putting the rest of your money into mutual funds, a retirement account or some other investment vehicle,” he said. “You don’t want to have every last penny tied up in your house, and the writeoffs (from the mortgage-interest payments) will shelter a lot of your income.”
Conversely, people who are in their late 40s or 50s may want to forgo the tax advantages that a large mortgage can provide and instead consider financing their next purchase with a 15-year loan.
“People who are in their 40s or 50s are in their peak earning years, so they’re the ones who will have the easiest time handling the higher monthly payments that come from a 15-year loan,” said Joe Knott, tax partner in the Los Angeles office of real estate consultants Kenneth Leventhal & Co.
“They won’t get all the writeoffs that a 30-year mortgage would give them, but they can make other tax-advantaged investments. The important consideration here is that they’ll have their home paid off by the time they retire.”
If you sell your home and you’re 55 or older, you’re eligible for a one-time tax exclusion that lets you keep up to $125,000 of your resale profits tax free. But there are some contingencies: The house must have been your primary residence for three of the past five years, and you can’t take the exclusion if you or your spouse have claimed it before.
Owning a second home isn’t as attractive today as it was under the old tax codes. Previously, you could count on hefty deductions to offset a large portion of the home’s carrying costs, such as loan payments, property taxes and utility charges.
Now, there are strict rules on who can take those writeoffs and who can’t. One set of rules applies to owners who use their hideaways infrequently, and another set applies to those who use them more often.
If you or a member of your immediate family stay in the home for more than 14 days--or for more than 10% of the number of days it’s rented to others, whichever is greater--the property will be classified as a personal residence. Stay in the property for 14 or fewer days, or less than 10% of the time it’s rented out, and the home will be considered a rental property.
If your second home is classified as a personal residence, you can only deduct your payments for mortgage interest and property taxes. Even then, you won’t be able to deduct all your interest if the loans on both your first and second homes total more than $1 million.
Should your hideaway be considered a rental property, you may be able to take writeoffs for depreciation, maintenance, homeowners fees and other items--as well as for mortgage payments and property taxes--if you actively manage the property.
Basically, you’re considered “active” if you manage the property yourself or if you personally select someone to manage the property for you. If you hire a manager, you can add an extra layer of protection against a possible tax audit by including a clause in the management contract that says you must personally approve new tenants and large repair bills.
The key to determining whether you’re better off treating the property as a residence or rental property is your adjusted gross income.
If your adjusted gross income is $100,000 or less and you actively manage the property, you can deduct up to $25,000 in losses that the property generates. This tax break is phased out for taxpayers who earn between $100,000 and $150,000.
Taxpayers who make more than $150,000--as well as those who aren’t active owners--can only write off losses the property generates if they have an equal or greater amount of “passive” income, such as earnings from a limited partnership.
“If the property is generating a lot of losses and you’re eligible to write them all off, you’ll probably be better off tax-wise by calling it a rental property,” Shenkman said. “It means limiting your use of the home, but the deductions may be worth it.
“On the other hand, if you can’t write off the losses, you’re probably better off calling the property a personal residence,” he said. That’s because you’d at least be able to deduct all your property taxes and mortgage-interest payments, as long as the total amount of debt on both your first and second home doesn’t exceed $1 million.
