"Only two things are inevitable: death and taxes." That's an old adage, but a third category has to be added to this list, namely "continuous talk of tax reform." Every year -- especially as we get closer to a Presidential election -- political candidates start their rhetoric about the vital need to reform our complex, outdated Internal Revenue Code.
Despite this talk, our tax laws have become more and more complex. It's difficult -- if not impossible -- to explain in simple English the laws involving depreciation of real estate, for example. Issues like the marriage penalty, capital gains and pension plans all take up hundreds of pages in the law books, and then the IRS has to issue complex regulations interpreting and explaining what Congress has directed.
On May 28, 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003. What a name! Tax professionals have to create shortcuts for all these new laws, and the latest is commonly referred to as JGTRRA. This new law has to be read in conjunction with the Economic Growth and Tax Relief Reconciliation Act of 2001 (which is fondly referred to as EGTRRA). Why? Because EGTRRA had some trigger dates to become effective in 2006, but JGTRRA pushed some of these dates back to 2003.
For example, tax rates have been lowered. The 27 percent rate drops to 25, the 30 percent down to 28, the 35 percent goes to 33, and the highest bracket of 38.6 is reduced down to 35 percent. But don't get too excited about this, since many of these tax amendments will cease as of year 2011.
Sounds complicated? It certainly is.
What is not complex, however, is that tax time is once again upon us. Unless you opt for the four-month automatic extension by filing application form 4868, all personal income tax returns must be filed no later than Thursday, April 15th of this year.
There are a number of tax advantages available for most American homeowners, but you have to understand them and report them properly to the IRS.
This series of articles is designed to assist homeowners in understanding the real estate tax laws -- both residential and investment -- so that you can take advantage of every tax benefit that is available. Keep in mind that if you are in the new 33 percent Federal tax bracket, for example, every additional dollar you can legally deduct, will be saving you 33 cents that does not have to go to Uncle Sam.
Net Profit -- you have to subtract any improvements you have made to the property, and also any real estate commissions or other sale-related expenses you pay when you sold the property. The bottom line net profit is also referred to as "capital gain." Despite all of the talk about tax reform, homeownership remains the Great American dream, and continues to be endorsed, encouraged and supported by our Federal Tax Code. Consider this typical scenario: In 1968 you bought your first home for $25,000. (Yes, homes were selling for that price back then!) You and your spouse had two children, and your first home was just too small. You sold your home for $65,000 and bought a new one for $80,000.
Your profit -- not taking into consideration expenses, improvements, or real estate commissions -- was $40,000. But since you were then able to take advantage of a tax benefit known as the "rollover," you did not have to pay tax on these capital gains. The rollover was completely eliminated when President Clinton signed into law the Taxpayer Relief Act of 1997.
One of the principal features of the great American dream was to encourage homeowners to continue to move up in their lifestyles. However, the Taxpayer Relief Act dramatically changed this concept. As will be seen in subsequent columns, homeowners are now permitted to exclude up to $250,000 of profits made on their principal residence ($500,000 for married taxpayers filing joint returns). And this exclusion is not limited to any one sale, but can be taken every two years -- so long as you meet certain eligibility criteria.
Congress also repealed the "once in a lifetime" exemption, whereby homeowners over the age of 55 were given a one-time absolute exclusion of up to $125,000 of the overall profit made on the sale of their principal residence.
Thus, the "rollover" and the "once in a lifetime" exclusion are history, having been replaced by a more simplistic -- and more financially rewarding -- concept: Up to $500,000 of profit can be excluded every two years.
For those of us who own homes, and are preparing to file our 2003 tax returns, here is a list of the itemized tax deductions available to most homeowners:
Mortgage Interest. 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, but file separately, the limits are split in half.
The concept of an acquisition loan is very important, and has confused -- and even trapped -- a large number of homeowners. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home. However, any other excess may qualify as a home equity loan. As this column has reported in the past, both the IRS and this columnist do not support loans which exceed the total equity in your house. It is too dangerous a risk to take, since your home is probably your most valuable asset.
Let us look at this example: Several years ago you purchased your house for $200,000 and obtained a mortgage (or deed of trust) in the amount of $160,000. Last year, your mortgage indebtedness had been reduced to $140,000, but because the market dramatically increased, your house was worth $300,000.
Because you wanted to pull out some cash from the equity in your home, you refinanced and were able to get a new mortgage of $200,000. For tax purposes, your acquisition indebtedness is $140,000 (i.e. the amount of your existing loan). The additional $60,000 that you took out of your equity does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan.
The Internal Revenue Service has issued a ruling that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you would have borrowed $250,000, you can only deduct interest on $240,000 of your loan -- the $140,000 acquisition indebtedness, plus the $100,000 home equity.
The remaining interest is considered personal interest, and is not deductible. This is an important concept for homeowners to consider. The interest that you pay on your credit cards -- which we know is generally computed at a very high, unconscionable rate -- is not deductible for tax purposes.
You should also note that for all practical purposes, there are no restrictions on the use of the money that you obtain from a home equity loan. You no longer have to justify your loan as meeting certain educational or medical requirements.
Taxes. Property taxes, both state and local, can be deducted. However, it should be noted that real estate taxes are only deductible in the year they are actually paid to the government. Thus, if last year you escrowed monies with your lender for taxes to be paid in 2004, you cannot take a deduction for these taxes when you file your 2003 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 2003. Review your settlement sheet carefully. Line 106 on page one of that statement should reflect this tax adjustment. Since this was a current payment by you for real estate taxes, it is a deductible item. Indeed, if your lender requires an escrow for taxes, when you receive your annual statement from that lender showing the amount of taxes paid last year, this additional amount will not be included in that statement. Lenders are required to send these annual statements to borrowers by the end of January of each year, reflecting interest and taxes paid for the previous year.
Points. When you obtain a mortgage loan, you often have to pay one or more points to get that loan. Whether referred to as "loan origination fees," "premium charges," or "discounts," they are still points. Each point is one percent of the amount borrowed; if you obtain a loan of $240,000, each point will cost you $2,400.00.
Next: The Concept of Principal Residence
