Careful Planning Can Help Make 1995 Less Taxing for Homeowners
It’s that time of year again--time to close the books on 1995 and figure out if there’s anything that can be done before the year’s end to minimize impending taxes, especially those related to real estate.
Many current and former property owners in the San Fernando Valley and Ventura County will pay too much in income taxes, but careful planning can help save substantial sums of money, local accountants and tax attorneys say.
Deferring capital gains:
Republicans and Democrats are still arguing about how to balance the budget, but it appears increasingly likely that they will at least agree on a capital gains tax cut. While the current proposal to cut capital gains taxes would be retroactive to Jan. 1, 1995, Congress and the president may delay the start of the tax cut until Jan. 1, 1996.
If that happens, realizing a gain in 1996 instead of 1995 would be the best strategy for taxpayers, said Terry Krupczak, director of tax at Ernst & Young in Woodland Hills.
The tax cut proposal currently on the table in Washington would slash capital gains taxes by a whopping 50%. Individuals in the 15% income tax bracket would pay an effective capital gains tax rate of 7.5%, those in the 28% bracket would effectively pay 14% and those in the top bracket of 39.6% would pay 19.8% on capital gains. Deferring the sale of a property into 1996 may be the wise choice, Krupczak said, if the seller plans to realize a capital gain that isn’t being rolled over into another property.
There are several circumstances in which property owners may be liable for capital gains tax. Knowing the rules, though, can help minimize or eliminate that tax.
Property owners who received insurance or other compensation from property that suffered a casualty will ordinarily have a taxable gain if the compensation received exceeds the adjusted basis of the property.
The adjusted basis of your home is equal to the purchase price of your first home, plus any difference between the value of that home when it was sold and the value of the next home you have purchased. The adjusted basis is also increased with any permanent improvements you put into any of your residences. If the adjusted basis of your property was $100,000 and you received $150,000 from your insurance company to pay for earthquake repairs, you could be liable for tax on $50,000 in capital gains.
Homeowners who use insurance money or other compensation to restore their residences don’t currently have to pay the capital gains tax. If the residence cannot be restored, the gain can be deferred by using that gain toward the purchase of another residence. The replacement period for the property involuntarily converted as a result of a presidentially declared disaster--such as the Jan. 17, 1994 earthquake--was extended by Congress in 1993 to a period of four years after the close of the first taxable year in which any part of the gain upon conversion is realized.
You do not have to include grants received under the Disaster Relief and Emergency Assistance Act in your gross income--such as grants from the Federal Emergency Management Agency. However, you may not deduct a casualty loss to the extent that you are specifically reimbursed by such a grant.
Maximize capital losses:
Current law doesn’t allow taxpayers to claim a loss on the sale of their principal residence. For many sellers in the San Fernando Valley who have lost equity in their homes, that has meant no tax relief when selling their homes at a loss. If the Republican Congress has its way, taxpayers who sell their homes and lose money would get to claim that loss to offset other income.
This proposed change in reporting capital losses was a part of the original Republican “contract with America.” Whether Congress and the president can get together on this issue is still a mystery. “There is still a good chance the proposal will become law,” Krupczak said. The one catch to the proposal is that if there’s a 50% capital gains tax cut, there will also probably be a 50% exclusion for claiming capital losses.
Deferring a capital loss, like the sale of a residence for less than its purchase price, until 1996 may increase the chances that at least part of the taxpayer’s loss can be used to offset other income.
Maximize casualty losses:
Homeowners who suffered casualty losses such as earthquake, fire, flood or landslide damage may be able to deduct a significant part of those losses from their taxable income.
Casualty losses are calculated as the difference between fair market value just before and just after the earthquake, or what’s known as the adjusted basis of the residence--whichever is the lesser, said Henry A. Lehrman, a certified public accountant in Los Angeles. Because casualty losses will in essence be limited to the adjusted basis of your home, you want to be able to document as high an adjusted basis as possible to maximize your ability to write off casualty losses for tax purposes, Lehrman explained.
“The IRS doesn’t make it easy for people to take casualty losses,” Lehrman said. “They’ve purposely made it difficult.”
Lehrman has been advising homeowners who suffered casualty losses to get an appraisal and to be sure that all the casualty losses are documented properly in case of an audit. The cost of the appraisal and of photographing the residence can be reported as miscellaneous deductions, Lehrman said.
Many homeowners claimed casualty losses related to the 1994 Northridge earthquake on their 1993 rather than 1994 tax returns, thanks to a special dispensation from Uncle Sam. It’s still not too late for taxpayers to amend their 1993 or 1994 tax returns if they have discovered additional casualty losses since they last reported such losses on their taxes, Lehrman explained. Casualty losses are reported on Internal Revenue Service Form 1040-X, the amended U.S. individual income tax return.
If you sold your home in 1995:
Homeowners can defer capital gains on the sale of a home indefinitely by rolling over their gain on one home into another home of equal or greater value. Homeowners age 55 or older who sell their home and don’t move up also have a one-time opportunity to realize up to $125,000 in tax-free gain on the sale of a primary residence. Even if you moved from one home in 1995 into another of equal or greater value, local experts say, it is advisable to have a full accounting of any improvements made to the house to minimize future tax liability.
Repairs, as opposed to improvements, generally don’t count toward raising the tax basis of a home, unless these repairs are made in anticipation of selling the house. Pre-sale repair expenses may be accounted for on Internal Revenue Service Form 2119.
Home sellers should be sure they write off all their mortgage and property taxes paid in 1995, including some of these moneys that may have been paid through an escrow company. Many property owners don’t realize that escrow companies frequently pay a prorated share of the seller’s mortgage and property taxes when a transaction doesn’t close right on the first or last day of a month.
If you bought a home in 1995:
If you bought a house last year and paid points on your loan, those points are currently deductible. If you paid two points to the lender on a $200,000 loan, for example, you would have an extra $4,000 tax deduction. The one limitation to this write-off is that any points you deduct on your income taxes can’t exceed your down payment.
Now that you own a home, it’s time to get organized. Keep a record of what it cost to buy the home, because all those expenses will raise the adjusted basis of your home and eventually spare you capital gains tax. Home-buying expenses that count toward boosting your adjusted basis include attorneys’ fees, title search and insurance, late closing charges, the cost of cleaning up title, brokers’ commissions, property surveys, appraisal fees and the cost of recording. Any permanent improvements you make to your home will count toward helping save on capital gains one day if you decide to sell and not buy another home of equal or greater value.
More information about the cost basis of your home is available by ordering a free IRS publication called “Tax Information on Selling Your Home.” This booklet and IRS Form 2119, which is used to figure the cost basis of your old home and the so-called adjusted basis for any new home purchase, are available by telephoning the IRS toll-free at (800) TAX-FORM.
Minimize cancellation of debt tax:
The IRS now requires lenders who forgive part of a borrower’s debt to report cancellation of debt, or COD, as income on Form 1099. COD can happen in one of several ways. A lender may foreclose on a homeowner and recover less than the amount due the lender. A lender may also voluntarily agree to accept less than the full value of the note in what’s commonly known as a short sale.
In these situations, a borrower would be liable to the IRS for COD tax, unless the borrower had a non-recourse loan--most typically a so-called purchase money loan used to buy a residence--or unless the borrower falls within the bankruptcy or insolvency exceptions of the IRS. Much of this is explained in more detail in the IRS rules accompanying form 1099-A, titled “Acquisition or Abandonment of Secured Property.” Because this area of the tax law is not all clearly delineated, taxpayers should consult a certified public accountant or tax attorney who is very familiar with COD.
