Advice to Help Homeowners Save at Tax Time

American society has always encouraged people to own their own home. Indeed, there is significant legislation in the Federal Tax Code that is designed to encourage homeownership.

For example, many years ago you bought your first home for $30,000. Several years later, after you had been married and had children, your old home was too small. After

selling it for $60,000, you bought a new principal residence for $62,000.

One of the significant tax benefits available to the homeowner is known as the “rollover,” which will be discussed in more detail in another article in this series. However, the basic thrust of the rollover was to permit you to buy a larger, more expensive home and not have to pay tax on the gain that you previously made.

But the Congress of the United States also recognized that at some point in time, when the children moved out of your home, you ultimately would want to sell the family home and move into a smaller place, such as a retirement home or a condominium. Indeed, you might decide not to buy anything more at all.

Thus, many years ago Congress created the “once-in-a-lifetime exclusion,” which permits homeowners over the age of 55 to shelter a fixed amount of profit. Today, that amount is $125,000. This once-in-a-lifetime exclusion will also be discussed in detail in this series.

These two tax-saving devices still remain in the tax law. However, in 1986, Congress enacted major tax reform that significantly affected the real estate industry. These new tax changes primarily affected investors in real estate, but also started to whittle down other tax benefits available to homeowners--such as deduction of points paid for a real estate loan. This series will also include a discussion of investor real estate tax issues.

The future tax situation is quite cloudy. President Clinton has indicated that he will try to raise taxes on high-income taxpayers. Whether these tax increases will spin off on homeowners is, at this early stage, unclear.

However, the basic homeowner deductions are still available, and this series will discuss the general tax rules for real estate owners and investors.

Today’s column will provide a preliminary list of tax deductions available to the average homeowner.

Taxes. Property taxes, both state and local, can be deducted. This deduction is available even if you have only a partial interest in the property, such as owning the property jointly with another person. And the amount of money that you pay for the real estate taxes controls your deductions. If, for example, you are a joint owner of the property, but nevertheless pay more than your partial interest, you are still entitled to deduct the entire amount that you paid.

It should be noted that real estate taxes are only deductible in the year they are actually paid to the government. Thus, if you impounded money with your lender in 1992 for 1993 taxes, you cannot take a deduction for these taxes when you file your 1992 return.

However, if you bought a house last year, you probably reimbursed your seller for a portion of the prepaid taxes through the end of 1992. Review your settlement statement carefully. Line 106 on page 1 of the statement will reflect this tax allocation. Since this is a payment by you for real estate taxes, it is a deductible item.

Mortgage interest. At the end of each year, your mortgage lender will provide a statement indicating how much interest you paid during the past year and what the current principal balance is on your mortgage.

Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million and home equity loans up to $100,000.

If you are married and file separately, the limits are split in half.

Keep in mind that Congress used the words “acquisition loans.” To qualify for such a loan, you must buy, construct or substantially improve your home. If you obtain a refinance loan for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan. However, it may qualify as a home equity loan.

Example:

Several years ago, you purchased your house for $150,000 and obtained a mortgage of $100,000. Last year, your mortgage indebtedness had been reduced to $95,000, but your house was worth $300,000.

You refinanced and obtained a new mortgage of $175,000. The acquisition indebtedness is $95,000. The additional $80,000 that you pulled out of the equity does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan.

The IRS has ruled that you do not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you had borrowed $200,000, you would be able to deduct interest only on $195,000 of your loan--the $95,000 acquisition indebtedness plus the $100,000 home equity.

The remaining interest is treated as personal interest. As of 1991, none of that interest is deductible.

It should also be noted that for all practical purposes, there are no restrictions on the use of the money obtained from a home equity loan. You no longer have to justify your loan as meeting certain educational or medical requirements, as was the case in 1987.

Points. When you obtain a mortgage loan, you often have to pay one or more points to get that loan. Points are often referred to as “loan origination fees,” “premium charges,” or “discounts.” Each point is 1% of the amount borrowed; if you obtain a loan of $150,000, each point is $1,500.

In 1992, the Internal Revenue Service ruled that it will permit a deduction for points paid during a taxable year if the following five requirements are met:

(1) The settlement sheet must clearly designate the amount of points incurred.

(2) The amount must be computed as a percentage of the principal loan amount. In other words, each point must represent some identifiable percentage--for example, 1%, 3%--and not just a flat, arbitrary fee.

(3) The point must be paid to acquire the taxpayer’s principal residence and the loan must be secured by that residence.

(4) The points must be paid directly by the taxpayer, and may not be borrowed as part of the total loan transaction. Although the IRS ruled in 1991 that points do not have to be paid separately to be deductible, it is still advisable if you write a separate check to the lender or the escrow company to reflect that these points were paid by you.

(5) The amount paid must conform to the business practice of charging points in the area in which your house is located.

Points paid to refinance your house may or may not be deductible. If you make substantial improvements to your house and refinance for the purpose of paying these improvements, then the points would be deductible.

On the other hand, if you are merely changing one interest rate loan for another, or pulling out new money from your house, the points are not deductible in full, but have to be allocated over the life of the loan.

It should be noted, however, that if you refinance a refinanced loan, the unallocated points from the previous loan are deductible in full in the year that you obtain the subsequent refinance loan.