SDC Tax and Business Services

With the advent of the home sale gain exclusion back in the 1990s, taxpayers have been using that provision of the law in a popular strategy to exclude gain not just from their primary residence but also from rentals and second homes as well.  

They do that by moving into the rental or second home and making it their primary residence for two years, then selling it and excluding the gain, up to $250,000 ($500,000 for joint filers). 

To qualify for the exclusion, each taxpayer must own and occupy the home as their primary residence for two of the five years prior to the sale and must not have utilized the exclusion in the two years immediately preceding the sale.  Thus, with careful planning, taxpayers could employ this technique on multiple properties.

Apparently, this strategy became too popular and Congress included a provision in the recently-enacted Housing Assistance Act of 2008 to curtail gain exclusion attributable to periods of ownership when the property was not the taxpayer’s primary residence.  The new law accomplishes this by prorating the home sale gain between qualified and nonqualifed use periods and allowing the home gain exclusion to apply only to gain from qualified periods.

Example: An individual taxpayer purchases a home on 1/1/09 and rents it.  On 1/1/11, he occupies the property as his primary residence and then sells the home in 1/1/13 for a $200,000 gain.  Prior to this law change, the entire $200,000 could have been excluded.  However, under the new law taking effect after 2008, the taxpayer would have to apportion the gain between the periods when it was a rental and when it was a personal residence.  In this example, he owned it four years, of which time use for two years was nonqualified.  Thus, 50% of the gain ($100,000) would be attributable to a nonqualified use period and would not be excludable.  As a result, the taxpayer would be able to exclude only $100,000 of the $200,000 gain.  Note that had the taxpayer used the home as a second home instead of a rental, the results would have been the same.

The law does provide a pretty liberal definition of nonqualified use.  A period of nonqualified use means any period during which the property is not used by the taxpayer or the taxpayer's spouse or former spouse as a principal residence, except as noted below.  For purposes of determining periods of nonqualified use, do not include any period:

o Before January 1, 2009,

o After the last date the property is used as the principal residence of the taxpayer or spouse (regardless of use during that period), and

o Not to exceed two years that the taxpayer is temporarily absent by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.

If your planning strategies include employing multiple sales, each qualifying for the home sale exclusion, you should carefully analyze the impact of this new law on your plans.  Please call this office if you have any questions.

Unless the taxpayer qualified for the over 55 exclusion, profits from home sales prior to May of 1997 were generally deferred into the replacement home. This, in effect, reduced the tax basis of the replacement home, so that when it is sold, the profit from the previous home are taken into account when determining the overall profit from both homes. With the current law allowing a $250,000 ($500,000 for qualified couples filing jointly) exemption, many individuals forget about the deferred gain from the first home finding out after the fact that their profit is larger than expected.

For example, a single individual makes a profit of $175,000 from the sale of a home in 1994. That profit is deferred into a replacement home costing $300,000. Now the replacement home is sold for $500,000. Without considering improvements or sales costs, the overall profit from the replacement home is $375,000 (the $200,000 profit from the replacement home plus the $175,000 profit deferred from the previous home). After taking into account the $250,000 gain exclusion, the taxpayer would end up with a taxable profit of $150,000. Since there is no longer any deferral of profits, the $150,000 will be taxable.

Often, when a couple separates and divorces, one spouse continues to live in the family home. Frequently, the departing spouse will simply quitclaim the property to the spouse retaining the home. When filed, the quitclaim deed takes the departing spouse's name off the title. However, it does not remove that spouse's name from the mortgage. 

So if you quitclaim a property to your spouse and he/she is late with payments, it will hurt your credit rating. To make matters worse, there is no way for you to get your name removed from the loan. Frequently, divorce attorneys fail to consider this adverse consequence. It may be in your best interest to require that the home be sold, or that your spouse refinance it as part of the divorce agreement.

Unless they meet the reduced exclusion qualifications, taxpayers must meet the ownership and use tests in order to qualify for exclusion of gain. This means that during the 5-year period ending on the date of the sale, taxpayers must have:

1) Owned the home for at least 2 years (if a joint return only one spouse need meet the ownership test), and

2) Except for short temporary absences, lived in (used) the home as their main home for at least 2 years.

The required 2 years of ownership and use during the 5-year period ending on the date of the sale do not have to be continuous. Taxpayers meet the tests if they can show that they owned and lived in the property as their main home for either 24 full months or 730 days during the 5-year period ending on the date of sale. 

Temporary Absence: Generally, a temporary absence would be for illness, education, business, vacation, military service, etc. for less than one year and the taxpayer intends to return to the home, and continues to maintain the home in anticipation of such return.

Selling Land that is Part of Your Home: Special rules apply to the sale of land on which a taxpayer’s main home is located and may or may not qualify for exclusion.

Maximum Exclusion: A taxpayer can exclude the entire gain on the sale of their main home up to:

1) $250,000, or

2) $500,000, if all of the following are true:

a) The taxpayers are married and file a joint return for the year.
b) Either the taxpayer or the taxpayer's spouse meets the ownership test.
c) Both the taxpayer and taxpayer's spouse meet the use test.
d) During the 2-year period ending on the date of the sale, neither the taxpayer nor the taxpayer's spouse excluded gain from the sale of another home.

CAUTION: The term “first-time homebuyer” is used both in the context of the penalty-free IRA withdrawal discussed in the article and the first-time homebuyer credit discussed in the article immediately following this one.  Be careful in that the definition of a first-time homebuyer is different for both.

Each taxpayer who qualifies as a "First-Time Home Buyer" can make a $10,000 penalty-free withdrawal from an IRA to purchase a home. (Please note that even though the withdrawal might be penalty-free, it is still taxable).

However, the tax law definition of a first-time homebuyer is quite different from the literal definition of a first-time homebuyer. As it turns out, you can qualify even if you owned a home before or even if you are helping certain family members purchase a home. To qualify for the first-time homebuyer penalty exception, the distribution must meet all of the following requirements:

1. Used to pay qualified acquisition costs before the close of the 120th day after the distribution was received.

2. It must be used to pay qualified acquisition costs for the main home of a first-time home buyer (defined later) who is any of the following:

• Taxpayer, taxpayer's spouse.
• Taxpayer or spouse's child or grandchild.
• Taxpayer or spouse's parent or other ancestor.

3. When added to all the taxpayer's prior qualified first-time homebuyer distributions, if any, the total distributions cannot be more than $10,000. If the taxpayer is married, both can withdraw up to $10,000.

First-time homebuyer - Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, or build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement.

Contact this office for more details on how utilizing this exception may impact your tax consequences.

First-time homebuyers may wish to take advantage of a new tax credit included in the Housing and Economic Recovery Act of 2008.
Available for a limited time only, the credit:

• Applies to home purchases after April 8, 2008, and before July 1, 2009.

• Reduces a taxpayer's tax bill or increases his or her refund, dollar for dollar.

• Is fully refundable, meaning that the credit will be paid out to eligible taxpayers, even if no tax is owed or the credit is more than the tax that is owed.

However, the credit operates much like an interest-free loan, because it must be repaid over a 15-year period. So, for example, an eligible taxpayer who buys a home today and properly claims the maximum available credit of $7,500 on his or her 2008 federal income tax return must begin repaying the credit by including one-fifteenth of this amount, or $500, as an additional tax on his or her 2010 return.

CAUTION: Taxpayers are cautioned that this credit is a loan, and except under some special circumstances noted in this article, it must be repaid.  Do not take this credit if you will be unable to meet the repayment requirements in the future.  The repayment is subject to the same penalties and interest and collection procedures as any other income tax when not paid on time.  In addition, your withholding or estimated payments may need to be adjusted to avoid the underpayment penalty.

Definition of a First-Time Homebuyer - A taxpayer is considered a first-time homebuyer if he (or spouse, if married) had no present ownership interest in a principal residence in the U.S. during the three-year period before the purchase of the home to which the credit applies. If the individual is married, neither the individual nor his spouse may have had a present ownership interest in a principal residence during that three-year period, even if they file as married taxpayers filing separately. Ownership of a home outside the U.S. during the three-year period will not disqualify the taxpayer.

When to Claim the Credit - If an eligible purchase is made in 2008, the first-time homebuyer credit can be claimed on your 2008 tax return. For an eligible purchase in 2009, the credit can be claimed on either your 2008 (or amended 2008 return) or 2009 return.

Homes That Qualify - Only the purchase of a main home located in the United States qualifies.  Vacation homes and rental property are not eligible. The home must be purchased after April 8, 2008, and before July 1, 2009. For a home that is constructed, the purchase date is the first date the home is occupied.

Amount of the Credit - The credit is 10 percent of the purchase price of the home, with a maximum available credit of $7,500 for either a single taxpayer or a married couple filing jointly. The limit is $3,750 for a married person filing a separate return. Unmarried taxpayers who purchase a home together are eligible to share the credit under an as-yet-to-be announced formula to be determined by the IRS.  In most cases, the full credit will be available for homes costing $75,000 or more. Whatever the size of the credit a taxpayer receives, the credit must be repaid over a 15-year period.

Income Limits – The purpose of the credit is to assist lower-income individuals in acquiring their own home. Thus, the credit is reduced or eliminated for higher-income taxpayers. The credit is phased out based on the modified adjusted gross income (MAGI). MAGI is the adjusted gross income plus various amounts excluded from income-for example, certain foreign income. For a married couple filing a joint return, the phase-out range is $150,000 to $170,000. For other taxpayers, the phase-out range is $75,000 to $95,000.  This means that the full credit is available for married couples filing a joint return whose MAGI is $150,000 or less and for other taxpayers whose MAGI is $75,000 or less.

Who Cannot Take the Credit – In addition to the other qualifications and limitations discussed above, a taxpayer cannot take the credit if the:

• Home is purchased from a close relative. This includes a spouse, parent, grandparent, child or grandchild.

• Home is no longer used as the main home.

• Home is sold before the end of the year in which it was purchased.

• Taxpayer is a nonresident alien.

• Taxpayer is, or was, eligible to claim the District of Columbia first-time homebuyer credit for any taxable year.

• Home financing comes from tax-exempt mortgage revenue bonds.

How and When is the Credit Repaid - The first-time homebuyer credit is similar to a 15-year interest-free loan. Normally, it is repaid in 15 equal annual installments beginning with the second tax year after the year the credit is claimed. The repayment amount is included as an additional tax on the taxpayer's income tax return for that year. For example, if a $7,500 first-time homebuyer credit is properly claimed on the 2008 return, the taxpayer will begin paying it back on his or her 2010 tax return. Normally, $500 will be due each year from 2010 to 2024.

A taxpayer may need to adjust his or her withholding or make quarterly estimated tax payments to ensure that they are not under-withheld.

However, some exceptions apply to the repayment rule. They include:

• Taxpayer’s Death - If a taxpayer dies, any remaining annual installments are not due. If a joint return was filed and the taxpayer passes away, the surviving spouse would be required to repay his or her half of the remaining repayment amount.

• Ceases Being Main Home - If a taxpayer stops using a home as the main home, all remaining annual installments become due on the return for the year that happens. This includes situations where the main home becomes a vacation home or is converted to business or rental property. There are special rules for involuntary conversions.  

• Home Sold - If a home is sold, all remaining annual installments become due on the return for the year of sale. The repayment is limited to the amount of gain on the sale, if the home is sold to an unrelated taxpayer. If there is no gain or if there is a loss on the sale, the remaining annual installments may be reduced or even eliminated. For example, a home is purchased for $200,000 and the credit of $7,500 is claimed.  Assume that no improvements are made on the home and it is sold for $195,000 after repaying $500 of the credit.  The gain or loss would be measured for purposes of the accelerated credit recapture from $193,000 (the original cost of $200,000 less the $7,500 credit plus the $500 repayment).  In this case, there would be a gain of $2,000 on the sale ($195,000 - $193,000).   Thus, the taxpayer would only be liable for repaying $2,000 of the credit when the home is sold.  Had the home sold for $193,000 or less, there would be no repayment required.

• Divorce - If a home is transferred to a spouse, or, as part of a divorce settlement, to a former spouse, that person is responsible for making all subsequent installment payments.

• Involuntary Conversion - If the home is involuntarily converted (e.g., it's destroyed in a storm), and the taxpayer buys a new principal residence within a two-year period beginning on the date of the disposition or the date the home ceases to be the principal residence, the accelerated recapture rule does not apply.  However, the regular recapture rule applies to the replacement principal residence during the recapture period in the same way as if the replacement principal residence were the converted residence. 

It may be appropriate to consult with this office in advance of a home purchase where you or a family member are contemplating on utilizing this credit.  

Most individuals go shopping for their dream home rather than a fixer-upper when they are looking for a place to call home. However, if you are handy, willing and able to buy a home with the intention of fixing it up and reselling it, you have a unique opportunity for tax-free profits up to $250,000 ($500,000 for a married couple).

Under current law, homeowners can sell their main home not more frequently than once every 24 months and pocket the profits (up to the limits) tax-free. All that is required is that the taxpayer(s) own and live in the property for two of the five years preceding the sale.

If you are so inclined, real estate sources indicate that "good" fixer-uppers include those homes that are basically sound and well located with the "right things wrong". Good fixer-uppers include those with peeling paint, worn-out carpet, old-fashioned fixtures, tiered or no landscaping, need for just minor repairs, and worn but serviceable kitchen cabinets. By making cosmetic repairs, owners of "good fixer-uppers" often add at least $2 in market value for every $1 spent fixing up.

If you're thinking of purchasing a home, have you considered how you intend to hold title to the property? Surprisingly, many home purchasers don't give much attention to the question even though the manner in which title is held can have far-reaching ramifications.

The best way to come to a decision about title is to consult with a real estate attorney. Before you do that, however, you may want a little background on the more prevalent title-holding methods:

• Title held in the name of one individual. Single individuals would probably be the most likely candidates for this method of holding title. However, married individuals may also, for one reason or another, choose to take title individually rather than with their spouse. When the owner of the property dies, probate is necessary. However, the property takes on a new value for beneficiary—equal to its fair market value at the date of the original owner's death.
  
  
• Joint tenancy with right of survivorship. Under this form of ownership, all (two or more) owners hold title to the property. Each owns an equal share of the property and when one owner dies, the others become owners of the decedent's portion. An advantage of joint tenancy is that it cuts probate costs since the decedent's portion of the property normally reverts to the remaining joint tenants automatically (ownership recording, of course, need to be changed). The basis of the decedent's part is revalued at date of death.
  
  
• Community property. Married couples in community property states of Arizona, California, Idaho, Nevada, New Mexico, Louisiana, Texas, Washington, and Wisconsin can claim community title to property. Under community property rules, each spouse owns half of the property and each spouse can pass his/her portion either to the other spouse or to someone else. An advantage of community property is that when it is willed to a surviving spouse, the entire property gets revalued to fair market value at the date of the decedent spouse's death.
  
  
• Community property with right of survivorship. Beginning July 1, 2001, married couples in California will be able to hold title to property as "community property with right of survivorship". This new law combines the tax benefits of holding title as community property including a double step-up in basis with the ease of property transfer available to the survivor of joint tenancy property, which requires the surviving spouse to inherit the property and allow title to change without court action.

Others methods of holding title, like tenancy in common or holding property in trust, are also available. All have their "special" pros and cons. Before making final decisions about the method of taking title that's best for you, take some extra time to check them out.

Many parents of college age children would like to utilize the equity in their home to help pay for college expenses. When considering this course of action, there are two issues: (1) Should the first trust deed be refinanced or should a second trust deed line of credit be secured? and (2) Will the interest be deductible?

The decision whether to refinance the first trust or to obtain a second trust deed will depend on several factors including how favorable the interest rate is on your current mortgage, how much it will cost to refinance, how much you need to borrow and how long you will remain in the home. Generally, if your interest rate is near the prevailing rate for new mortgages, it will be better to obtain a second loan or a line of credit. The line of credit has the added advantage that you can draw on it as needed rather than trying to estimate your needs in advance and borrowing a lump sum. If you are planning to sell your home within the near future, the cost of refinancing the first mortgage is probably not warranted. On the other hand, if your current mortgage is more than 2 points higher than the prevailing mortgage rates and you plan to remain in the current home for the foreseeable future, it is probably better to refinance first mortgage anyway.

The tax laws associated with deducting home mortgage interest can be tricky if you have previously refinanced or have mortgages in excess of one million dollars. However, if your current mortgage is less than the one million and you have never previously taken any equity out of the home, you can borrow up to an additional $100,000 and still deduct all of the interest.

Most often, examples demonstrating exclusion of home sale gain is applied to single individuals or married couples. This gives the false impression that the $250,000 ($500,000 for married couples) exclusion applies to the home itself. Quite the contrary, the $250,000 exclusion is available to each individual who qualifies under Sec. 121 of the Internal Revenue Code. For example, if four friends jointly own a home and each meet the requirement of at least two years "aggregate" occupancy during the five years before the sale, each is eligible for a $250,000 exclusion.

Heirs of property are often concerned about the taxes they will owe on any gain from that property's sale. After all, the property may have been purchased by a deceased relative years ago at low cost, but now has vastly appreciated in value. The usual question is: "Won't the taxes at sale be horrendous?"

Clients are usually pleasantly surprised by the answer—that special rules apply to figuring the tax on the sale of any inherited property. Instead of having to start with the decedent's original purchase price to determine gain or loss, the law allows using the value at the date of the decedent's death as a starting point (sometimes an alternate date is chosen). This often means that selling price and basis in the property are practically identical and there is little, if any, gain to report. In fact, the computation often results in a loss, particularly when it comes to real property on which large selling expenses (realtor commissions, etc.) must be paid.

Other than possible large gains, sales of certain inherited assets can also cause other concerns—particularly the sale of the home a decedent lived in just prior to death. Like other inherited real property, the sale often produces a loss. However, losses on personal-use assets normally aren't deductible. Since the decedent had used the home personally, the worry is that any loss is going to be nondeductible.

Fortunately, under special circumstances, the courts have allowed deductions for losses on an inherited home. In order to deduct such a loss, a beneficiary must try to sell or rent the property immediately following the decedent's death. In one case where a beneficiary was also living in the house with the decedent at the time of death, loss on a sale was still deductible when the heir moved from the home within a "reasonable time" and immediately attempted to sell or rent it.

Surviving Spouse – The foregoing rules generally do not apply to a surviving spouse who inherits the deceased spouse’s interest in a home. Special gain exclusion rules apply to a surviving spouse beginning in 2008.

If you are planning on refinancing your home, you might be concerned about whether the interest on the loan is deductible. Here's an overview of the current home mortgage interest deduction rules that should help answer your questions.

• Interest on your new loan will be 100% deductible if interest on your old loan was fully deductible and you're refinancing the old loan dollar-for-dollar.
  
  
• If your new loan amount is more than the balance on the old one but you use the new money to substantially improve your home, you can generally deduct all the interest on the refinanced loan, provided the new loan amount totals less than $1 million.
  
  
• If your new loan amount is more than the balance of the old one but you don't use the new money to substantially improve your home, your interest will generally still be 100% deductible if new money isn't over $100,000.

Points on the refinanced loan: Points paid in connection with buying or substantially improving a principal home are currently deductible. However, if you pay points on a refinance loan, they are currently deductible only if:

1. They are paid out of your own cash at the closing of the loan (in other words, the points aren't withheld from your loan proceeds), and

2. The new loan proceeds are used to substantially improve your home.

So if you refinance your existing mortgage and use none of the proceeds to substantially improve your home, the points aren't deductible in full in one year. Instead you must deduct the points ratably over the life of your new loan.

Prepayment penalty: If you must pay a penalty for paying off your old mortgage early, you'll get also a tax benefit. The prepayment penalty is fully deductible in the year it's paid.

Because many complications cloud the tax rules for deducting home mortgage interest—for example, you may have several mortgages on your home, or own two homes you use personally—we suggest that you call this office to discuss the details of your situation before making final decisions about refinancing. The extra planning could save you a substantial amount on your taxes.

If you have a mortgage on your real estate property, you should be keeping an eye on interest rates. Rates have come down considerably over the last few months and are expected to take another dip in the near future. This may provide you with a favorable opportunity to refinance your property.

The decision to refinance may not be solely predicated on obtaining a lower interest, but can depend upon a variety of individual circumstances and needs such as:

• Eliminate PMI Charges – Your original loan may have Private Mortgage Insurance (PMI) payments that you cannot get removed. With the recent increase in property values, you may have enough equity in your home to avoid the PMI charges with a new loan.
  
  
• Obtain a Lower Interest Rate – With interest rates approaching the lowest level in several years, refinancing could lead to lower payments.
  
  
• Replace a Variable Loan with a Fixed Loan – If your current loan is a variable one, this may be your opportunity to switch to a fixed rate mortgage.
  
  
• Consolidate Debt – Although individuals should exercise restraint in tapping the equity from their home, for those with burdensome consumer debt, refinancing may offer the opportunity to convert high interest rate, non-tax deductible consumer debt into deductible home mortgage debt at lower interest rates.
  
  
• Combine Multiple Existing Mortgages – If you have multiple mortgages on your property, the interest rates on the second or third mortgages may be substantially higher than the prevailing interest rates. Refinancing and rolling all the debt into a new first mortgage at prevailing rates may make sense.
  
  
• Finance A Child's Education – Looking for ways to finance your children's education? If you have sufficient equity in you home, it may make sense to refinance your home for the cash needed to finance their education. This is probably a better option than tapping taxable retirement funds or taxable assets.
  
  
• Finance a Business Transaction – Using your home equity to finance the purchase of business assets will probably provide a lower interest rate than a business loan. However, financing business needs with a home loan often leads to tax complications, and you should consider the tax ramifications before proceeding.

Some taxpayers use revocable trusts as an alternative to having their property transferred by will. While there is no income or estate tax advantage to a revocable trust, there is a benefit in having the property pass to beneficiaries on the death of the owner without having to go through the probate process.

However, there is a potential pitfall where a married couple transfers their residence to a revocable trust that becomes irrevocable after the first spouse dies – the $250,000 home sale exclusion may be completely lost or available only to a limited extent even though the surviving spouse has the continued right to occupy the residence. An IRS Letter Ruling (PLR 200104005) indicates the exclusion is available only to the extent the survivor is considered to own trust property. In this ruling, a couple, living in a community property state, established a revocable trust while both were living. Upon the death of the spouse, the trust was split into two trusts, the irrevocable bypass trust and the survivor's revocable trust. The home was assigned to the irrevocable bypass trust, and therefore, the surviving spouse is not considered to own the property and any subsequent sale would not qualify for the home sale exclusion.

If a taxpayer has more than one home, the taxpayer can only exclude gain from the sale of the taxpayer’s main home (principal residence), even if the other home meets the 2 out 5 ownership and use test. 

Main Home: The property that the taxpayer uses the majority of the time during a year will ordinarily be considered the taxpayer’s “main home” or “principal residence.” A taxpayer’s main home can be a house, houseboat, mobile home, cooperative apartment or condominium. In addition to the taxpayer's use of the property, relevant factors in deciding whether a property is his principal residence include, but aren't limited to:

• Taxpayer’s place of employment;
• Where the family members live;
• Address listed on taxpayer’s income tax returns, driver's license and auto and voter registration;
• Taxpayer’s mailing address for bills and correspondence;
• Where the taxpayer maintains bank accounts; and
• Where the taxpayer maintains memberships (e.g., places of worship, clubs, etc.). 

Example: Figure #1 illustrates a situation where a taxpayer has two homes, both of which meet the ownership test. The taxpayer also meets the occupancy test, since the taxpayer has lived in both homes more than two years of the prior five-year period. However, only the New York home qualifies, since the taxpayer lived in the New York home the majority of the time in all five preceding years, thus qualifying it as the taxpayer’s main home.

C		H
New York    Home		California  Home
Main Home  Months              Qualifying Lived In                  Months  7                             7    7                             7      7                             7      7                             7     7                             7   35                           35	Calendar       Year         One        Two        Three        Four        Five     TOTAL	Main Home   Months              Qualifying Lived In                Months 5                         0  5                         0  5                         0 5                         0 5                         0 25                        0

 

If you have ever refinanced real property such as a rental, vacant land, or even your home, you have essentially taken out a portion of the profits without actually selling the property. That means when you sell the property, your taxable gain may exceed the amount of cash you actually receive in the transaction.

Illustration: Suppose you originally paid $120,000 for your home ($20,000 down and a $100,000 mortgage) and then a few years later, after the property had appreciated in value, you refinanced the loan for $200,000. Later, you sell the property for $250,000 net of sales costs. Your cash from the transaction is $50,000 (the 250,000 selling price less the $200,000 mortgage). However, your taxable gain is 130,000 (the $250,000 selling price less the cost of $120,000). If this was your home, the $130,000 might not present a problem if you qualify for the home sale exclusion. If not, you are faced with $130,000 taxable income and only $50,000 cash from the transaction.

When a home purchaser's down payment is less than 20%, they must obtain Private Mortgage Insurance in order to get a loan. This is about one in every three new loans. Getting rid of the Private Mortgage Insurance will save you considerable money, but it is not easy to get rid of. Even with the law enacted in 1999, it remains difficult to get mortgage companies to drop the requirement.

The borrower pays it, but the lender gets the benefit -- PMI assures the lenders will get back their money if the borrower defaults on the mortgage loan. The insurance isn't cheap either, $39 a month for someone who puts 10% down on a $100,000 loan and $62 at 5% down.

The Homeowners Protection Act, which became effective on 7/29/1999 provides some relief, but still favors the lenders. Here are the highlights of that law.

• It only applies to new mortgages, signed on or after July 29, 1999.
• Lenders must automatically cancel the PMI when the mortgage reaches 78% of the purchase price.
• Borrowers can request that the PMI be dropped when the mortgage balance reaches 80% of the purchase price.
• It ignores how the appreciation in value adds to equity, which ought to make PMI disappear sooner.

If your home has appreciated in value so that you have 20% equity, you could refinance. However, paying closing costs to cancel the PMI payment will reduce or eliminate your cost savings. Refinancing also subjects you to today's higher interest rates.

So what's a savvy homeowner to do? Stay on top of the property values in your neighborhood and contact your lender to ask about its policies toward PMI. Many lenders will offer to drop the PMI policy when asked, although they may first require you to pay for an appraisal to show you have reached 20% equity.

If a taxpayer does not qualify for the full exclusion, they may still qualify to exclude a reduced amount if the taxpayer(s) did not meet the ownership and use tests, or the exclusion was disallowed because of the once every 2-year rule, but sold the home due to:

a) A change in place of employment, 

b) Health, or 

c) Unforeseen circumstances to the extent provided in IRS regulations. The following are examples of unforeseen circumstances for qualified taxpayers:

1. Involuntary conversion of the residence;
2. Natural or manmade disasters or act of war or terrorism resulting in a casualty to the residence;
3. Death of an individual; 
4. The loss of employment making the taxpayer eligible for unemployment compensation;
5. A change in employment status that results in the taxpayer being unable to pay housing costs and reasonable basic living expenses for the household; 
6. Divorce or legal separation under a decree of divorce or separate maintenance; and 
7. Multiple births resulting from the same pregnancy.

Amount of Reduced Exclusion – If qualified, the reduced exclusion is determined on an individual basis and in the case of married taxpayers, the individually computed amounts are combined for the joint exclusion. To determine the reduced exclusion, multiply $250,000 (maximum exclusion amount) by a fraction whose denominator is 720 and numerator is the shorter of:

(1) The number of days, during the five-year period just prior to the current sale that the property was owned and used by the taxpayer as his/her principal residence, or

(2) If you sold a home just prior to the current sale and the exclusion applied to that sale, the number of days between that sale and the current sale.

There are a number of reasons to consider refinancing: lower payments, lower interest rates, eliminating PMI payments, home improvements, college funds, consolidating debt, purchasing a second home, or even financing a business venture.

When considering such a move, remember there are costs associated with refinancing and any decision to refinance will depend upon whether the overall financial benefits warrant the expense to refinance. Things to consider include:

• How long will you own the property? If you plan to sell in the near future, you may not save enough from refinancing to warrant the cost.
  
  
• Will the interest from the new loan be fully deductible? There are deduction limitations on mortgage interest, and you might find that a portion of the interest you pay on the new mortgage may not be deductible.

Is refinancing the right thing for you? Let us help you determine if the expense of refinancing is justified, or if there are other options that might be more practical. Taking the proper course of action now can have a profound impact on the future.

Over the past few years, mortgage interest rates have dropped significantly and homeowners in increasing numbers are refinancing their home mortgages and in the process, have extended the term of the loan and are frequently taking additional cash out to pay down other debts, finance education, buy a car, etc. In doing so, homeowners may be unwittingly creating a situation where part of their home mortgage interest may no longer be deductible. Generally, the mortgage interest that you may deduct on your home includes the acquisition debt and $100,000 equity debt, provided the combined debt does not exceed the value of the home or $1,100,000.

The root of the problem is that acquisition debt is not a fixed amount, and it steadily declines to zero over the term of the original purchase mortgage. If that mortgage is refinanced and the new term extends past the term of the original mortgage or the amount of the mortgage is increased, then the amount of the replacement debt that exceeds the original acquisition debt will no longer qualify as acquisition debt. This still may not present a problem so long as the replacement debt never exceeds the original acquisition debt plus the allowable $100,000 of equity debt illustrated in the figure below. The green shaded area represents the debt on which interest would be deductible as home mortgage interest while the red shaded area represents a the portion of a refinanced debt on which the interest would not be deductible as home mortgage interest.

Example: From the illustration above, the home was refinanced in the 15th year for $300,000. At the time of the refinance, the original acquisition debt plus the $100,000 equity debt totaled $250,000. Therefore, the amount of interest from the new $300,000 debt will be limited to the interest on $250,000 or 83.3% of the total mortgage interest (250K/300K).

If you have or might refinance, it is imperative that you retain a record of the terms of the original acquisition debt in case you exceed the debt limitation and need to prorate your interest deduction.

When refinancing, you also need to watch out for the Alternative Minimum Tax (AMT). The AMT is another way of computing tax liability that is used, if it is greater than the regular method. Congress originally conceived the AMT as means of extracting a minimum tax from high-income taxpayers who have significant items of tax shelter and/or tax-favored deductions. Since the AMT was conceived, inflation has driven up income and deductions so that more individuals are becoming subject to the AMT.

When computing the AMT, only the acquisition debt interest is allowed as a deduction, home equity debt interest is not. Neither is the interest on debt for unconventional homes such as boats and motor homes, even if they are the primary residence of the taxpayer.

Before you refinance a home mortgage, it may be appropriate to contact this office to determine the tax implication of your planned refinance and see if there are any other suitable alternatives.

Depreciation: The tax law assumes business assets will decline in value due to obsolescence and wear and tear. Therefore, taxpayers are allowed to take an annual deduction called depreciation, which represents the decline in value. If the asset is later sold for more than its depreciated value, any gain attributable to the depreciation is generally taxed at rates higher than the gain would otherwise be taxed.

In addition, the home sale exclusion does not apply to any depreciation taken on the home after May 6, 1997. This means that even if the gain is less than the allowable exclusion, the portion that represents depreciation after May 6, 1997 will still be taxable.

Mixed-Use or Separate Property? When a home that was used entirely or partially for business is sold, the home gain exclusion may be limited and some portion of the business deduction for depreciation may be taxable. How much of the gain is taxable and the amount of gain that is subject to the gain exclusion depends if the business portion was part of the dwelling unit (mixed-use property) or whether it was a separate structure.

• Mixed-Use Property: When the business use was within the same dwelling unit, no allocation of gain is required between the business portion and the personal (home) use portion. However, any depreciation attributable to periods after May 6, 1997 would be taxable to the extent of any gain. Allowable depreciation reduces the basis of the home.
  
  Example: Jake, a single taxpayer, sells his home for $350,000. He had originally purchased the home for $55,000 and added a room, which cost $25,000 giving him a cost basis of $80,000. He also had an office in the home for which the allowable depreciation before May 7, 1997 was $2,500 and after May 6, 1997 was $3,000. The cost of selling the home was $27,000. He meets up to $250,000.
  
  Sales Price……………………………....................$350,000
  Less Sales Expenses………………….................<27,000>
  Cost Basis………………………......80,000
  Allowable depreciation……...........<5,500>
  Tax Basis……………………………….....................<74,500>
  Gain………………………………………....................248,500
  Home Sale Exclusion………………….....................<250,000>
  Net Gain (losses not allowed–not less than zero)........0
  Taxable Amount (depreciation after 5/6/97)…..........3,000

• Separate Property: When the business use was within a separate structure such as a guesthouse or detached garage, the tax treatment will depend upon whether the separate structure itself meets the exclusion qualification requirements. 
  
  
• Mixed-Use Property Sales: The IRS has made it quite clear that the business portion that the exchange of a home can qualify for both the §121 home sale exclusion and §1031 like-kind exchange deferral treatment. This can occur where the property was used as a principal residence and a business consecutively (e.g., use as a principal residence followed by rental of the property) or concurrently (a portion of the home used as a principal residence and a portion used as a home office). Please call this office for addition information regarding how to qualify for the tax deferral of the business portion gain. The sale of mixed use property can create some complicated issues. Clients are advised to review their option with this office prior to initiating a sale.

These days, more individuals are working from home offices and availing themselves of the "Home Office Deduction." For tax purposes, this deduction essentially divides your home into two separate pieces of property, your home and business property. Those taking the deduction will be able to deduct a portion of the home operating expenses including interest, taxes, insurance, utilities, upkeep and office depreciation. Since taxes and interest are generally deductible and any depreciation taken is added back to income when the house is sold and taxed at 25%, the real net benefit of taking a home office deduction lies with deducting the business portion of the utilities, insurance and upkeep.

• For Employees - the home office is deducted as a miscellaneous itemized deduction, which means an individual must itemize their deductions in order to benefit from the deduction. Since taxes and interest are generally deductible and any depreciation taken is added back to income when the house is sold and taxed at 25%, the real net benefit of taking a home office deduction lies with deducting the business portion of the utilities, insurance and upkeep. In addition, the miscellaneous itemized deduction is reduced by 2% of your gross income so they might not be deductible, depending upon the size of your annual income.
  
  
• For Self-Employed Individuals - the benefits of a home office deduction are more substantial since the home office deduction is taken on the Schedule C and not subject to the limitations of itemizing deductions. In addition to offsetting income tax, a home office deduction can also reduce self-employment tax for individuals whose net income is subject to self-employment tax. For self-employed individuals, there are also some income limitations, so the deduction may be limited and any are carried over to a future year.

The tax trap occurs when you sell your home. If the office is an integral part of your home, the entire gain from the home and the business portion qualifies for the exclusion of gain except for the business depreciation taken after 5/6/97. If the business portion is separate, the gain from that portion would not qualify for the exclusion and would be taxable. See Sale of Home Used for Business for additional details.

If you rent part of your property, such as a room or a portion of the house, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property. You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses. You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as utilities and home repairs (such as painting the outside of your house). You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint the room that you rent or pay premiums for liability insurance in connection with renting a room in your home, the entire cost is a rental expense. If you install a second phone line strictly for your tenant’s use, all of the cost of the second line is deductible as a rental expense. You can also deduct depreciation on the part of the property used for rental purposes, as well as on the furniture and equipment used for that purpose.

Generally, the most frequently-used methods of allocating expenses between personal use and rental use are: (1) based on the number of rooms in the home, and (2) based on the square footage of the home. You can use any reasonable method for dividing the expense. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them.

If a taxpayer sells the land on which their main home is located but not the home itself, the taxpayer generally cannot exclude the gain from the sale of the land with one exception. The exclusion would apply to the sale or exchange of vacant land that the taxpayer owned and used as part of his principal residence, if the disposition of the dwelling unit occurs within two years before or after the disposition of the vacant land. The vacant land must be adjacent to land containing the dwelling unit, and the sale or exchange of the vacant land must otherwise meet the qualifications for exclusion. In addition, the excluded gain cannot exceed the amount that would be allowed had the properties been sold in one sale.

When a married couple sells a jointly-owned home that has been owned and used as their primary home for two of the prior five years, they can exclude up to $500,000 of gain from the sale of the home. They can only do this once every two years, unless the sale is related to a job move.

But what happens when two single individuals marry and each owns a home and both homes are sold within the same two-year period? Tax law allows them to sell their individual homes on a joint return within the same two-period. The amount they can exclude on each home is limited to $250,000. Each home is looked at separately based on the duration of the home's use and ownership by the individual that owned and used that home.

Example 1 — one spouse sells a home. Emily sells her home in June. She marries Jamie later in the year. She meets the ownership and use tests, but Jamie does not. Emily can exclude up to $250,000 of gain on a separate or joint return.

Example 2 — each spouse sells a home. The facts are the same as in Example 1 except that Jamie also sells a home. He meets the ownership and use tests on his home. Emily and Jamie can each exclude up to $250,000 of gain.

If you're considering buying a home, here's a checklist of some of the things you should be on the lookout for:

Check your credit rating – Before applying for a loan, pre-check your credit rating to make sure there are no surprises. The advantage of the pre-check is that it gives you time to get the report corrected before approaching a lender. If there are credit blemishes in your record that can't be removed, you will know they are there and be prepared with an explanation.

Get pre-qualified – Before starting to look for a home, consult with your mortgage broker to see just how large a mortgage you qualify for. There is nothing worse than falling in love with a home you can't afford. Nothing less expensive will ever seem as nice.

Get pre-approved – Apply for a mortgage and obtain a commitment from your lender, in writing, to fund your loan as long as the home you buy appraises for that loan amount. Costs for pre-approval are nominal and can usually be paid when the loan is closed.

Prepare a reality list plus a wish list – The two lists should detail everything you want in the home such as a spa, formal dining room, gourmet kitchen, air conditioning, etc. The reality list includes everything you can't live without and the wish list includes only the "frills". If you get everything on the reality list and some of the items from the wish list are within budget, you will be doing very well.

The only interest that is still deductible as an itemized deduction is home mortgage interest and investment interest. If you are like so many others with large consumer debt such as credit cards, car payments etc., you are paying interest that is not deductible. If the amount of consumer interest you pay each year is substantial and you itemize your deductions, you may want to consider converting that nondeductible interest into deductible interest by paying off the consumer debt with a home equity line of credit. Generally, current law allows individual taxpayers to borrow up to $100,000 of home equity and dedu