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Interest
on Home Mortgages
 As you plan your year-end tax movers, be sure you're
up to date with your payments on mortgage and home-equity
loans that carry deductible interest. You may be able
to beef up your home-mortgage deduction by making your
December payment before year-end, even if it's not
due until the following January.
If you make a payment on your mortgage or home-equity
loan late in the year, the interest portion might not
be included on the Form 1098 your lender sends you
and the IRS to show how much interest was paid during
the year. Watch this point carefully. If you mail the
check by December 31, you get the deduction in the
current year even if the lender doesn't register the
payment until the following year. But you'll need to
attach a note to your tax return explaining the discrepancy
between the Form 1098 and the amount you're deducting.
Points
on Home Mortgages
Points paid on a mortgage to buy your principal residence
remain fully deductible in the year paid, assuming
the points amount to prepaid interest, which they almost
always do. If you plan to settle on a home around the
end of the year, closing the deal and paying the points
by New Year's Eve can give you a big deduction on the
tax return you file the following spring.
Home
Equity Loans and Tax-Saving Opportunities
The special status of home-equity debt offers great
tax-saving opportunities. If you can exchange nondeductible
personal borrowing for deductible home-equity borrowing,
you get Uncle Sam's help paying the interest on your
debts. This makes home-equity lines of credit the debt
of choice for millions of homeowners. These loans offer
a line of credit-which you can usually tap simply by
writing checks-secured by your home. In addition to
preserving the deductibility of interest charged, these
loans often carry lower interest rates than unsecured
borrowing.
That makes a home-equity line of credit a powerful
tool. Beyond considering this source for your future
borrowing needs, you may want to tap a home-equity
line to pay off higher-priced debt on credit cards,
auto loans and personal notes. Trading $10,000 of 18%
nondeductible debt for $10,000 of 5% deductible debt
would slice the after-tax carrying costs from $1,800
to $365 a year for a taxpayer in the 27% bracket.
Although the tax law encourages consumers to borrow
against their homes, a note of caution is necessary.
To qualify for the tax deduction, these loans must
be secured by your home, which means that if you find
yourself unable to repay, your home is at stake. Don't
let the siren song of deductible interest pull you
into a deal if you don't fully understand the terms.
If you consider a home-equity loan, shop carefully.
The cost of setting up the line of credit varies widely
and can be stiff. Interest rates and repayment schedules
also differ substantially.
When you buy a home, the rules on acquisition indebtedness
may encourage you to hold down your down payment. Remember
that the size of your tax-favored debt is based on
your original mortgage-not the price of the house.
The law can also encourage you to borrow to pay for
a home improvement rather than to pay cash. As long
as the debt is secured by the home, the amount that
pays for the improvement counts as acquisition debt.
The tax subsidy of the interest cost could make borrowing
cheaper than the amount you'd lose by pulling cash
out of an investment to pay for the improvement.
It's important to keep reliable records of your borrowing
to back up the deductions you claim. If you use a home-equity
line, carefully distinguish between borrowing that
pays for major home improvements and loans used for
other purposes. The amount that goes for improvements
is added to your acquisition debt, rather than eating
away at your $100,000 home-equity allowance. Also,
if you use money borrowed on a home-equity line of
credit or second mortgage for investment or business
purposes, you can choose whether to treat the interest
as home-equity interest or deduct it as investment
or business interest. If, for example, you opt to count
it as investment interest, the borrowing would not
reduce your $100,000 home-equity allowance.
Refinancing
If you refinance a mortgage-as millions of homeowners
have done to take advantage of lower interest rates
in recent years-there are tax angles to consider.
Points you pay to get the new mortgage are not fully
deductible in the year paid, except to the extent that
the funds are used for home improvements.
Here's an example: A homeowner with a $100,000 mortgage refinances at $120,000
and uses $20,000 to build a swimming pool. Assume that two points (2% of
$120,000, or $2,400) were charged. Because one-sixth of the money went for
a home improvement, one-sixth of the points, or $400, may be deducted in
the year paid. The rest must be deducted evenly over the life of the loan.
On a 30-year mortgage, that would basically mean one-thirtieth of the remaining
$2,000, or $66.66, would be deducted each year, assuming the homeowner remembers
to do so.
If the house is sold and the mortgage paid off before the end of the term,
any remaining portion of the points could be deducted as interest at that
time. (If the refinancing is part of the original purchase of your home-say
you refinance to pay off a bridge loan or a short-term balloon note-the points
can be fully deducted in the year paid.)
Refinancing can affect the tax status of the interest
you pay on the mortgage. The amount of the new loan
qualifying as acquisition debt is limited to the debt
outstanding on the old loan, plus any part of the new
money used for major home improvements. This tale,
too, is best told with an illustration:
Assume that several years ago you bought a $150,000
home with $30,000 down and a $120,000 mortgage. The
debt is now paid down to $90,000 and you decide to
refinance for $150,000. What's the tax status of the
new loan?
Interest on $90,000-the balance on the old loan-is
sure to be deductible because that amount qualifies
as acquisition indebtedness. The treatment of the other
$60,000 depends on how the money is used.
Any part spent for major home improvements also earns
the status of acquisition debt. Plunge $20,000 of the
new loan into a swimming pool, for example, and your
acquisition debt jumps from $90,000 to $110,000. Any
part of the new loan that neither replaces the old
mortgage nor pays for improvements-$40,000 in this
example-is not acquisition debt.
That doesn't necessarily mean you can't deduct the
interest, however. Because the debt is secured by your
home, the interest may be deducted as home-equity interest,
subject to the $100,000 cap. If the extra funds are
used in a business, the interest can be written off
as a business expense. If you use the cash for an investment,
the interest may be deductible as investment interest,
within limits.
If none of those options protects you, however, the
interest would be nondeductible personal interest.
Another tax issue rising out of some refinancings
is how to treat prepayment penalties. If the lender
holding the original loan slaps you with a penalty
for paying it off early, the amount is considered interest
and is fully deductible in the year you pay it.
But what if the lender is willing to cut the amount
due to encourage you to pay off the mortgage early?
That's not as unlikely as it may appear. In times of
soaring interest rates, lenders sometimes offer sweet
deals to get out of long-term loans at low, fixed interest
rates. But if you're on the receiving end of such an
offer, beware. The amount of such a discount is considered
taxable income to you.
Consider this example: You still owe $60,000 on a
7% mortgage at a time market rates have risen far above
that level. To get that low-rate loan off its books,
the lender offers to let you pay off the debt in full
for $50,000. If you agree to such a deal, the IRS wants
a share of your windfall. The $10,000 discount is considered
taxable income-costing you $2,700 in the 27% bracket.
If you are offered such a deal, be sure to weigh the
tax consequences.
Finally, if you refinanced to a lower rate, remember
that paying less interest will translate to a smaller
mortgage interest tax deduction. In effect, Uncle Sam
will claim part of your savings.
Equity
Sharing
Despite all the advantages of homeownership, rising
home prices can make it tougher than ever to afford
a home, particularly that first house. Coming up with
the cash for the down payment is often a family affair,
with parents helping their children buy into the American
dream of homeownership. The tax consequences of making
a low- or no-interest loan to help your children buy
a house are discussed above.
Here's a look at another path to the same goal that
may make sense for you: equity sharing.
The parties in a shared-equity arrangement don't have
to be related, but this discussion will focus on parents
and children. Basically, rather than making a loan
or gift to your child, equity sharing involves becoming
his or her partner. You become part-owner and rent
your share of the place to the child. As an investor,
you share in the appreciation of the house. As a landlord
you also get rental income and the tax deductions that
go along with rental real estate.
Assume the equity is split 50/50, although the property
does not have to be divided equally. You and your child
each put up half of the down payment and agree that
you will each pay half of the mortgage interest, property
taxes and other expenses such as insurance and repairs.
Your child would also have to agree to pay you fair
market rent for your half of the house.
The child, as the owner-occupant of the house, gets
the tax advantages of homeownership, on a scaled-down
level. The mortgage interest and property taxes he
pays are deductible, just as if he owned the house
outright. (Like any tenant, of course, he can't deduct
the rent he pays you.)
You, as the owner-investor, get all the tax advantages
of owning rental real estate. You report the rent you
receive as income and deduct the mortgage interest
and property taxes paid as a rental expense. You also
deduct your share of the insurance bills, for example,
and the cost of repairs. In addition, you can claim
depreciation deductions based on the cost of your half
of the house. Under current tax law, residential real
estate is deductible over 27.5 years and straight-line
depreciation is used. If your expenses outstrip the
rent you receive, you may be able to qualify to deduct
up to $25,000 of your losses against other income.
When the house is sold, you and your child will split
the proceeds. As an investor, your profit is taxable
in the year of the sale. Since the house is the child's
principal residence, however, he or she may defer the
tax bill by rolling the profit into a new home.
Setting a fair rent for your share of the house is
a key to whether a shared-equity arrangement will pass
muster with the IRS.
Remember that the owner-occupant
has to pay rent only on the part of the house you
own. In a 50/50 deal, if similar homes in the area
generally rent for around $1,000 a month, for example,
you wouldn't need to set the rent above $500. You
could probably set it somewhat lower, in fact, since
you can count on the owner-occupant to be a particularly
good tenant. Presented with such arguments a few
years ago, the U.S. Tax Court said that "fair rent" for
a relative can be as much as 20% lower than fair
rent for a stranger.
Shared-equity deals have to be set up under a written
agreement that spells out the conditions of the deal,
including each partner's share, which one will make
the house a home, how expenses will be split and the
fact that the owner-occupant will pay rent to the other
owner. Because of the complexities, if you're interested
in equity sharing, find a lawyer, real estate agent
or mortgage-company official who is familiar with these
arrangements. It may take some effort, but the tax
savings could be well worth the trouble.
Rental
Property
As part of their end-of-year tax planning, owners
of rental property can pull down their taxable income
by scheduling and paying for repairs on their units
before year-end. Be sure, too, that you're up to date
on paying other deductible expenses, such as property
taxes, mortgage interest and insurance premiums. These
costs will trim taxable rental income or increase your
loss.
As long
as you actively manage the property and your adjusted
gross income is under $100,000, you can deduct up
to $25,000 of rental losses against other income.
That $25,000 allowance is phased out as AGI moves between
$100,000 and $150,000. Any excess losses fall in the
category of "passive losses,'' which can't be
deducted unless you have passive income to offset.
Another exception allows certain real estate professionals-who
spend at least half their time and a minimum of 750
hours a year tending to their real estate-to deduct
their losses.
If your rental losses can't be written off because
of the passive-loss rules, forget about speeding up
rental expenses to get them in before year-end. The
extra loss will have no current tax benefit.
Vacation
Property: Christmas
at the Beach?
Owners of vacation property may have an extra incentive
to use their getaways around year-end. If you own property
that you rent out part-time, you probably are well
versed in the vacation-home rules: Use the place for
more than 14 days or 10% of the number of days it is
rented and the house is considered a personal residence.
That limits your rental-expense deductions to the amount
of rental income. In other words: no tax loss to shelter
other income.
Limit personal use to pass the 14-day test, though,
and the house is considered a rental property. Qualifying
it as such lets you deduct losses under the $25,000
rule-if you actively manage the place and your AGI
is below $150,000 so you're not tripped up by the passive-loss
rules.
In the past, the tax subsidy from writing off losses
was a key part of financing many vacation homes, so
owners were careful not to let personal use tip the
scales against them. Now, however, passing the rental-property
test can cost you mortgage-interest deductions. The
law permits you to deduct all mortgage interest on
your principal residence and a second home.
If you keep your personal use of the vacation place
under 15 days, however, it doesn't qualify as a second
home. That means mortgage interest attributed to your
use of the house is personal interest.
If your rental losses are threatened by the passive-loss
rules, you may find it advantageous to squeeze in enough
extra days of personal use at year-end to qualify the
vacation house as a second home. At least that would
preserve your mortgage-interest write-off.
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