If Tax Laws are
Crazy, then Owning a Home is your Therapy
The tax laws
have gotten crazy! They are totally out of
control. Every year there are rumors of
making it easier, but the maze seems to get
more complicated, more confusing with each
new wave of tax changes.
One area that
has remained relatively constant relates to
the tax advantages of owning a home. The
investment value aside, being able to deduct
your mortgage interest sweetens the pot when
determining how much house you can afford.
First, let's
just outline the many tax benefits from
owning a home:
-
The interest
you pay on your mortgage is tax
deductible.
-
The interest
you pay on a home equity loan or second
mortgage is deductible, but could be
limited.
-
The points you
pay when you purchase your home is
deductible. The points you pay when
refinancing are deductible, but not all at
once.
-
If you live in
your home two of the last five years, or a
minimum of two years, you can exclude all
of the gain, up to $500,000, when you sell
the home. And there is no requirement to
reinvest the money in a new home.
That doesn't
sound confusing. It's actually pretty clear,
right? Oh, but do not be deceived by its
appearance of simplicity. Not all mortgages
are created equal. In other words, there are
some basic rules that apply in determining
mortgage interest.
For example, all
loans must be secured by the home.
The home must be used as collateral on the
mortgage. For example, you have found a home
you want to buy, but you can't qualify for a
mortgage. Your parents agree to loan you the
money to purchase a house. You pay them
principal and interest each month, just as
if you were making a mortgage payment. You
are not allowed to take the deduction for
mortgage interest.
One potential
solution is to sign a contract with your
parents and record it with Register of
Deeds, pledging the house as collateral for
the loan.
You must have a
legal, binding obligation to repay the
mortgage. For example, you have found a nice
little starter home, but you can't qualify
for a mortgage. Your parents agree to take a
mortgage out in their name for you. Their
name is listed on the deed to the property,
but you are making all of the payments. You
are not allowed to take the deduction for
mortgage interest.
One potential
solution is to sign a contract with your
parents and record it with Register of
Deeds, pledging the house as collateral for
the loan.
The loan amount
can not exceed the fair market value of your
home. Many mortgage lenders and brokers now
offer loans in excess of the fair market
value of your property - commonly referred
to as 125 loans. This can be a good move if
you have credit card or consumer debt with
high interest rates. But it has its
pitfalls. First, you can only deduct part of
the interest - the part allocated to the
value of your home.
For example, you
own a home worth $240,000. You have a
current loan for $200,000 and credit
card/car loans as well as college loans in
the amount of $100,000. You have great
credit so your mortgage lender tells you can
borrow up to $300,000. The first year you
incur $18,000 in mortgage interest. You can
only deduct $14,400 - the portion related to
the value of your home.
Second, this is
the balance of all the loans on your home.
If you have a first mortgage and home equity
loan, the same rules apply. You would have
to combine the loan balances and determine
how much is above the fair market value of
your home.
Now let's
discuss particulars as it relates to first
mortgages, second mortgages, and home equity
loans. From here on, I am assuming that you
have passed the rules discussed earlier.
First, mortgage
interest and points can be deducted as an
itemized deduction in the year you pay them.
Second, there are mortgages and home equity
loans. There are two types:
Loans to
improve your existing home. If the
proceeds from your second mortgage are used
to increase the value of your home, the
interest and points are 100% deductible.
For example, you
take out a second mortgage to add a grate
room and bedroom to your existing
residence. The interest and points would be
deductible in the year you pay them.
Loans used
for other purposes. The interest is
deductible in the year you pay them where
the proceeds are used for other purposes,
but only up to $100,000 in mortgages.
For instance,
you take out a second mortgage of $30,000 to
pay off your credit cards. The interest
would be fully deductible since the loan
amount is below $100,000.
Points on this
type of loan are handled differently. You
deduct a portion of the points each year
over the life of the loan. But the good news
is that if you refinance that loan, you can
deduct the balance of the points.
For example, you
take out a second mortgage in 2003 for
$30,000 to pay off your credit card debt.
You pay $1,500 in points for a 15-year loan.
You can deduct $100 in 2003. In 2005, you
combine your first and second mortgages.
There is still $1,300 of points that have
not been deducted. You can deduct this
amount in 2005.
Now for the most
important question, how much can I actually
save in taxes if I buy a house? How much
house can I afford?
I have a
"little" talk I give to all of my clients. I
call it the "everyone-should-own-a-house"
speech. It goes kind of like this:
"There are
different expenses that you are incurring
right now that you can deduct from your
income. These are called itemized
deduction and include medical expenses,
taxes, interest, charitable contributions,
investment expenses and employee expenses
not reimbursed by your employer.
The catch is
that the IRS gives you a standard deduction.
I call it the just-because-you-are
deduction. For a married couple who file
together, that deduction is $9500; if you
are single, it is $4,250; if you are head of
household, it is $ 7,000.
So in order
for you to deduct these expenses, all of
them must be more than the standard
deduction (the just because you are
deduction).
For most
people, the quickest way to get over that
amount is through mortgage interest."
At this point,
most people physically back up. Their minds
start to cloud up. There eyes glaze over.
That's when I start with the drawings.
Let me show you
what I mean. Max and Minnie Doe are married.
They are renting a house in the suburbs for
$1,200 a month. Their itemized deductions
are:
Medical
None
State taxes from
their W-2 1,700
Personal
property on cars 600
Donations to
their church 2,500
Total itemized
deductions 4,800
Right now, they
would not itemize their deductions. They
would use the standard deduction of $9,500.
Now, let's say that Max and Minnie have
found the perfect house. They will have a
loan of $150,000 at 6%. The real estate
taxes are $2000/year; insurance,
$1,200/year. That means their new house
payment will be $1,165, which is $35 less
than the rent payment.
But it gets even
better. Starting with their $4,800 in
itemized deductions, now you add the
mortgage interest and real estate taxes. For
the first year, that comes to $9,000 of
mortgage interest and $2,000 in real estate
taxes. Now Max and Minnie have itemized
deductions of 15,800. Compared to the
standard, "just because you are" deduction,
they will reduce their taxable income an
additional $6,300.
If Max and
Minnie are in a 15% bracket, they will save
$845 a year in taxes. If they are in a 25%
bracket, they will save $1,575 in taxes. And
that's just federal taxes. They will also
save on their state taxes.
Consideration
and thought should always be used before
making an investment such as purchasing a
home, but from a tax perspective, it remains
one of the few tried and true deductions out
there. |
