IRS Opens the Door Wider for Home Tax Deductions
Janna Smith has been working from her La Canada Flintridge home for 10 years without ever attempting to claim a tax write-off for her office.
But that may be about to change. Homes, long a source of lucrative deductions, could prove to be even more valuable tax shelters this year.
Among the reasons: The year-long wave of mortgage refinancings, which can trigger write-offs for “points,” or pre-paid interest charges, and the Internal Revenue Service’s decision to issue a surprisingly generous clarification of the tax rules governing certain home sales.
The changes are of particular importance to Californians, many of whom have seen the value of their homes skyrocket in recent years. The IRS relaxed the residency requirements for sheltering some of the profits from a home resale, and also made it easier for home-based workers such as Smith to shelter more of their home-sale gains.
“The IRS has really gone out of its way to make [tax breaks for residential real estate] as widely available as possible,” said Michael J. Greenwald, a partner at national accounting firm BDO Seidman in New York.
“They seem to be saying that you should make the best decision for yourself and your family and they will make the tax rules as neutral as possible.”
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Home Sales
As in the past, people who sold their home last year can exclude up to $250,000 and married couples can exclude up to $500,000 in home-sale profits from taxable income on their 2002 tax returns, as long as the homeowner has lived in the residence for two of the last five years. Profits in excess of the excluded amounts are taxable at capital gains rates.
The tax code also includes a few exceptions that allow home sellers who don’t meet the minimum two-year residency requirement to still qualify for a partial exclusion. And recently, the IRS clarified the rules to make it easier to claim a partial exclusion.
Under the old rules, taxpayers could get a partial exclusion when a move was required by a change of employment, health reasons or “unforeseen circumstances.” But the IRS didn’t clearly define what it considered “unforeseen.” Last fall, the agency ruled that unforeseen circumstances could include:
* Divorce, legal separation or death of a spouse.
* Becoming eligible for unemployment compensation.
* A change in employment that makes it impossible to pay the mortgage or basic living expenses.
* Multiple births resulting from the same pregnancy.
* Damage to the home from a natural disaster, an act of war or terrorism.
* Condemnation, seizure or involuntary conversion of the property, such as through foreclosure.
The size of the deduction depends on how long the seller lived in the house during the five years before the sale. A taxpayer who lived in a house for a year -- or 50% of the two-year requirement -- would be entitled to a 50% exclusion. That would allow home-sale profit of $125,000 per person, or $250,000 per couple, to be sheltered from tax.
In addition, the IRS said that a move could be justified for health reasons if a physician recommended it for the physical betterment of the homeowner, the owner’s spouse or for certain close relatives.
Under the new interpretation, moving to care for a sick relative, for example, would qualify for the partial deduction, according to CCH Inc., a Riverwoods, Ill.-based publisher of tax information.
Also, a job-related move would qualify for a home-sale exception if the taxpayer’s new job was more than 50 miles farther away from the old home than the new workplace -- the same rule that already applied to taking deductions for moving expenses.
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Home Offices
The IRS reversed a rule that had deterred taxpayers such as Janna Smith from claiming a deduction for their home offices.
The IRS previously said that a taxpayer who wrote off a portion of a home’s value as a home office would lose the residential exclusion on that portion of the gain from a subsequent sale.
In other words, if 10% of the home -- based on one of several yardsticks, such as square footage -- was used as an office and the home was subsequently sold at a $100,000 profit, 10% of the profit, or $10,000, would be taxable.
Now the IRS says taxpayers can exclude as much of their home-sale profit as the law allows as long as the office is in the same dwelling -- in other words, if the office was a room in the house, not in a separate guest house or garage.
For Smith, who uses about 4% of her home as a dedicated home office, that eliminates the risk that she’ll lose a valuable exclusion by taking a relatively small deduction.
“Our accountant always felt the home office deduction wasn’t worth taking,” said Smith, who is an attorney. “But we’re definitely going to revisit this now.”
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Refinancing
There are no new rules regarding mortgage interest deductions, but the continuing refinancing boom has created a need for taxpayers to review the rules with respect to “points,” or pre-paid interest.
On a loan used to purchase a principal residence, all the points are deductible in the year they are paid, said Bob Walters, chief economist for *
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Quicken Loans.
On a loan used to purchase a second home or to refinance an existing mortgage, the points must be amortized over the life of the loan, he said. So a person who paid $3,000 in points on a 30-year mortgage would write off $100 of that expense -- $3,000 divided by 30 -- each year.
Serial refinancers -- those who refinanced a refinanced loan -- should note that any undeducted points from a previous refinancing become fully deductible when the new refinancing goes through.
In other words, if a taxpayer paid $3,000 in points on a 2001 refinancing and wrote off just $100 on his or her 2001 return, after refinancing again in 2002, the remaining $2,900 in undeducted points are deductible, said Walters.
Late fees and prepayment penalties also are deductible, Walters noted.
“It’s not something that you want to pay,” Walters said. “But if you had to go through the pain of having to pay a late fee or prepayment penalty, you might as well get the deduction.”
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Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@ latimes.com. For past Personal Finance columns visit The Times’ Web site at www .latimes.com/perfin.
