Tax Planning

• Interest on Home Mortgages
  
• Points on Home Mortgages
  
• Home Equity Credit: Tax-Saving
• Opportunities
  
• Refinancing
  
• Equity Sharing
  
• Rental Property
  
• Vacation Property: Christmas at the Beach?

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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