Financial transactions involving your home have many tax and financial implications and need to be approached with a full understanding of the process. This section is designed to help you learn all you can about home ownership and how it affects your finances.
Buying Your First Home
Homeownership is the dream of most Americans. It’s no small task, will consume a substantial amount of time, and includes a host of issues to consider. The following are some suggestions to help you through the process.
Are You Ready to Buy a Home?
Naturally, this is the first question you should consider. Ask yourself these questions:
• Do I have a steady source of income?
• Is my current income reliable?
• Have I been employed on a regular basis for the last 2-3 years?
• Do I have a good record of paying my bills?
• Do I have money available for a down payment?
• Am I credit worthy enough to qualify for home financing?
• Do I have few outstanding long-term debts like car payments?
• Do I have the ability to pay a mortgage every month, plus additional costs?
If the answer to most of these questions is “yes,” you’re probably ready.
When you’re applying for credit, lenders want to know your credit risk level.
Lenders will want to check your credit report and credit score when you apply for credit. If your credit score is low, you will probably end up with a higher interest rate, making your monthly home payments higher.
The most commonly encountered credit score is your FICO® score, which is easy to check online. Check your FICO® score six months before you plan to purchase a home, giving you enough time to verify the information on your credit report, correct errors if there are any, and take actions to improve your FICO® score if necessary.
The payoff from improving your FICO® score can be huge. For example, on a 30-year fixed mortgage of $150,000, you could save approximately $165,000 over the life of the loan – or $459 on each monthly payment – by improving your FICO® score from 550 to 720.*
*Based on average national interest rates as of September 2007.
Deductions Related to Your Home
Not all costs related to home ownership are deductible. However, you are typically able to deduct home mortgage interest and real estate taxes.
Home mortgage interest deductions can be limited. Equity debt interest is not deductible for Alternative Minimum Tax (AMT) purposes, so if you fall under the Alternative Minimum Tax (AMT) carefully consider the possibility of incurring home equity debt.
Disaster Casualty Losses
Disaster Casualty Losses are eligible for special tax benefits. A disaster loss is a casualty loss that occurs in a geographic area that the President of the United States declares eligible for Federal disaster assistance.
What is a Casualty Loss?
A casualty loss is property damage from a sudden, unanticipated event such as earthquakes, fires, hurricanes, tornadoes, floods, and storms.
Taxpayers within a federally declared disaster area can choose to claim their loss in the year it occurs or on the previous year’s return. When to take the loss depends upon several factors:
The tax brackets for each year – Determine which year will provide the greatest overall tax advantage without wasting other tax benefits.
The immediate need for cash – The primary purpose of the disaster casualty loss rules is to allow taxpayers to receive a tax refund without waiting to file their return for the year of the loss.
Self-employment tax – Self-employed taxpayers must decide whether to take a business casualty loss that affects inventory in the current or prior year because the loss can offset self-employment tax.
Whether the loss will be used up – If the casualty loss is not fully used in the year it is first deducted, it may create a net operating loss (NOL). An NOL can be taken back to prior years or carried forward to future years and used as a deduction.
Value of the Loss is Based Upon
The deductible loss is typically the lesser of the cost or adjusted basis or the decrease in fair market value of each item lost and then combined into one amount. The loss on real property is calculated on the whole property.
Business or Personal Casualty
Business casualty losses are fully deductible without limitations, while personal casualty losses are first reduced by $100 for each event and by 10% for the total of all events for the year. For personal casualty losses, deductions must be itemized.
H6. Calculating a Loss
To determine the deduction for a casualty or theft loss, figure out the loss first.
1. Determine the adjusted basis in the property before the casualty or theft.
2. Determine the decrease in fair market value of the property as a result of the casualty or theft.
3. Subtract insurance proceeds or other reimbursement received from the smaller of the amounts determined above.
Gain from Reimbursement
It’s actually possible to incur a gain from a casualty event if your reimbursement is more than the adjusted basis in the property. If there is a gain, you must pay taxes on it. If the gain is from a your main home and you have owned and lived in the home for 2 out of the prior 5 years, you may exclude $250,000 ($500,000 on a joint return) of gain.
Replacement Period for Postponed Gains
To postpone reporting gain, you have to purchase replacement property within 2 years, beginning on the date the property was damaged, destroyed, or stolen (or 4 years for homes located in federally declared disaster areas).
Home Destroyed is Still Treated as a Home
You can continue treating your primary or secondary home as a qualified home even after it is destroyed in a casualty so that mortgage interest may continue to be deducted. In order to do this, you must either rebuild the destroyed home and move into it, or sell the land on which the home was located within a reasonable amount of time.
Reimbursement for Living Expenses
Insurance proceeds received for a temporary increase in living expenses due to a casualty loss of a principal home can be excluded from taxable income. Living expenses include temporary housing, meals, transportation, utilities, and miscellaneous items.
Proving Casualty Losses
Taxpayers must prove the cost of the lost property and the amount of the loss. Photos of the property before and after are helpful, as are notes describing the property that was damaged, appraisals, and news clips describing the event. Blue Book values can be helpful in casualties that involve cars. Use a qualified appraiser to determine FMV of real property and scheduled personal property.
If you have a good credit rating and the money for a down payment, this is a good time to purchase a home because there many homes available and the prices are lower than they have been for many years.
The typical down payment required for the purchase of a home is 20% of the purchase price. If you don’t have the cash for a down payment, consider these sources:
Prior to 1998, taxpayers could claim a once-in-a-lifetime exclusion of gain from the sale of their primary home. The taxpayer or spouse must have reached the age of 55 prior to the sale in order to qualify, and they must have resided in the home for three of the prior five years.
The current law includes no age requirement for this exclusion. The taxpayer must have owned and occupied the residence two out of the past five years as their primary home. Taxpayers are allowed to exclude a gain every two years so long as they meet all requirements.
Special Military Rules: The five-year qualification period test can be suspended for up to 10 years for persons on qualified extended duty in the U.S. Armed Services or the Foreign Service.
If you’re handy, willing, and able to buy a fixer-upper home to resell, you have a unique opportunity for tax-free profits up to $250,000 ($500,000 for a married couple).
Currently, homeowners may sell their primary residence no more often than once every 24 months and keep the profits tax-free. They must simply own and live in the property for two of the five years preceding the sale.
Real estate experts say that ideal fixer-uppers are homes that are mostly sound, well located, and have the “right things wrong.” This includes homes with a need for minor repairs, worn-out carpet, peeling paint, poor or no landscaping, old-fashioned fixtures, and worn but serviceable kitchen cabinets. Cosmetic repairs can add at least $2 in market value for every $1 spent fixing up the property.
Parents or other relatives may assist a potential homebuyer by gifting them money to help with a down payment.
Holding Title to Your Home
The best way to decide how to structure your title is to consult with a real estate attorney. Here is a little background on the more common title-holding methods:
• Title held in the name of one individual. Single individuals most often choose this method of holding title, but married individuals may also choose to take title individually rather than with their spouse.
• Joint tenancy with right of survivorship. Two or more owners hold title to the property, with each owning an equal share of the property. When one owner dies, the others automatically become owners of the decedent’s portion with little paperwork required.
• Community property. Married couples in community property states of Arizona, California, Idaho, Nevada, New Mexico, Louisiana, Texas, Washington and Wisconsin may claim community title to property. Both spouses own half of the property and both can pass their portion either to the other spouse or to someone else. The advantage of this method is that the entire property gets revalued to its fair market value at the date of the decedent spouse’s death.
There are other title-holding methods available, so before making your final decision, thoroughly research the methods of holding title in your state to determine what’s best for you.
Home Ownership is Your Best Tax Shelter
Home ownership can provide you with several important tax benefits, including gain exclusion if you meet certain occupancy and holding period requirements and deductions for real estate taxes and home mortgage interest. Tax breaks are one of the biggest benefits to homeowners. Unfortunately, many homeowners don’t get the full benefit because they aren’t aware of the applicable tax rules.
Home Ownership vs. Renting
There’s a big difference between owning your own home and renting. Renters are free from most home maintenance tasks, but when you’re done renting, you have nothing to show for the money you spent. The purchase of a home provides significant both immediate and long-term benefits. Paying your mortgage builds equity, an important investment. Home ownership also qualifies you for tax breaks that help in dealing with your new financial responsibilities, like upkeep, insurance, and real estate taxes.
How Much Can You Afford
To begin, you’ll need enough cash up-front to cover your down payment and closing costs. And, unless you are purchasing a furnished model, you will need some money to cover modifications such as paint, curtains, etc. And, of course, you will incur expenses during your move.
What loan will you qualify for? Potential lenders consider your debt-to-income ratio, a comparison of your gross income to housing and non-housing expenses. The FHA recommends your monthly mortgage payments be no more than 29% of gross income. The lender will also consider the cash you have available for down payment and closing costs, your credit history, and other factors when determining your maximum loan amount.
Getting pre-qualified for a mortgage before you make an offer to a seller is quick and easy and lets you know ahead of time what kind of loan you qualify for. It also shows a seller that you are a serious buyer and puts you in a stronger position to negotiate a price on a home.
If you have an IRA account and you qualify as a first-time home buyer, you may make up to a $10,000 penalty-free (thought still taxable) withdrawal from your IRA to purchase a home. You can qualify for this provision even if you have previously owned a home. If neither you nor your spouse has had any present interest in a primary home during the past 2 years, you may qualify. The distribution must be used to pay qualified acquisition costs he total distributions cannot be more than $10,000 when added to all of the taxpayer’s prior qualified first-time homebuyer distributions.
Keeping an Eye on Interest Rates
Interest rates have been down lately, so if you have a mortgage on your real estate property, you should be keeping an eye on them. You may have an opportunity to refinance your property. But before you decide to refinance, you should consider other factors. We’ve highlighted a few below.
Combine Multiple Existing Mortgages
Do you have multiple mortgages on your property? Interest rates on second or third mortgages are often significantly higher than the prevailing interest rates, so refinancing and rolling all the debt into a new first mortgage at the current low rates might be a sensible option for you.
You should be judicious when tapping the equity from your home, but you have a significant amount of consumer debt, refinancing could allow you to convert that debt into deductible home mortgage debt at lower interest rates.
Eliminate PMI Charges
Does your loan have Private Mortgage Insurance (PMI) payments that you can’t get removed? If you have enough equity in your home, you might be able to refinance to avoid the PMI charges with a new loan.
Finance a Child’s Education
With sufficient equity in your home, refinancing your home can give you the cash needed to finance your child’s education and may even be a better option than tapping taxable retirement funds or taxable assets.
Obtain a Lower Interest Rate
Refinancing could lead to lower payments, as interest rates are at or near the lowest level in years.
Replace a Variable Loan with a Fixed Loan
If you currently have a variable loan, this could be your chance to switch to a fixed rate mortgage.
Maintaining Home Cost & Improvement Records
Homeowners have the ability to exclude up to $250,000 ($500,000 for a married couple) of gain from the sale of their home, a major tax advantage, but they must meet the ownership and use tests.
This means that, during the previous 5-year period, taxpayers must have owned the home for at least 2 years (if a joint return, only one spouse needs to meet the ownership test), and lived in the home as their main home for at least 2 years.
Those 2 years don’t have to be continuous; taxpayers must simply 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. If they don’t meet the requirements, they might still qualify for a reduced exclusion if the home was sold as a result of unforeseen circumstances.
It’s key to maintain good records to reduce any future gain and minimize any potential tax when the home is sold. Keep a copy of your purchase documents that itemize the costs of purchasing the property, along with substantiation for all subsequent improvements to the home.
Regarding Loan Points
Loan Points are prepaid interest; one point equals 1% of the loan amount. If points are paid for a lender to set up a loan, the points are non-deductible. When points are paid as a charge for the use of money, keep these rules in mind:
• Points are only deductible over the life of a loan, so if you pay off your loan off early, you could write off the balance of the points in that year.
• You can fully deduct points you pay in obtaining a mortgage to purchase, construct, or improve your main home.
• Seller-paid points can be deducted by a home buyer, but the amount deducted will reduce the home’s basis.
Reporting Gains and Losses
Exclusion of Gain:
If you sell your principal home at a gain, you may exclude some or all of the gain provided you’ve owned and occupied the residence for two out of the five previous years. You may claim a partial exclusion if the two-of-five year ownership and occupancy tests aren’t met, provided the sale is due to health, a job-related move, or unforeseen circumstances. It should be noted that second homes do not qualify for the exclusion of gain.
Previously Postponed Gain:
Prior to 1998, taxpayers could defer gain from the sale of a primary home into a replacement residence. Although gain deferral from a principal residence is no longer permitted, previous gains which were deferred into a home currently being sold must be accounted for.
Sales at a Loss:
A loss resulting from the sale of your primary home is non-deductible. This rule also applies to second homes.
Reporting the Sale of a Home
Reporting the sale of your primary residence is not necessary unless you have a gain and at least part of it is taxable.
Selecting a Real Estate Agent
The first person you talk to about buying a home will often be a real estate agent. You can hire your own real estate broker, known as a buyer’s broker, to represent your interests, since many sellers have their own broker who represents their interests, not yours. In some states, agents and brokers are allowed to represent both the buyer and seller.
It’s important to interview a real estate agent before choosing one, especially if you have multiple recommendations from friends. Look for an agent who listens well, seeks to understand your needs, and is familiar with the area in which you wish to purchase your home.
Shopping for a Loan
There are many different types of lenders and loans you can choose from and each will be able to offer you different settlement costs and mortgage payments.
• Mortgage Brokers – Some companies search on your behalf for a mortgage lender willing to make you a loan. Your broker may be paid by the lender, by the borrower (you), or both.
• Government Programs – You may be eligible for a loan insured through the Federal Housing Administration (“FHA”), guaranteed by the Department of Veterans Affairs, or similar programs operated by cities or states. These programs may require a smaller down payment.
The tax benefits available to homeowners can significantly reduce the cost of ownership. Mortgage interest and property taxes are a tax deduction (when itemized), providing considerable benefit and substantially offsetting the cost of owning the home.
Property taxes non-deductible by those subject to the alternative minimum tax (AMT). Your taxable income before and after the increase in deductions will often straddle two tax brackets and result in a blended marginal rate.
Remember that the yearly cost of your home will be more than mortgage payments and taxes; your lender will require your home to be insured, your utility bills may increase, and an allowance for home maintenance and repairs should be set aside.
Using Your Home Equity
Your home is one of your most valuable assets, and over time, you’ll pay down your mortgage and the home will increase in value, providing a substantial amount of equity.
The equity in your home can be a source of ready cash to use for other purposes, like purchasing vehicles, paying off credit card debts, or funding college educations. This actually provides a tax benefit because mortgage interest is usually – but not always – tax deductible.
A Source of Ready Cash
Many people see their home equity as a ready source of cash for purposes other than housing, and because consumer debt is not deductible as an itemized deduction, home equity is a great way to turn consumer purchases a tax deduction.
In addition to consumer purchases, home equity can be used for paying off credit card debts, paying college expenses, and covering emergency medical expenses. Just remember that your loan must be secured by your home, and if the total debt exceeds combined acquisition debt and equity debt limits, the excess is not deductible as home mortgage interest.
A home under construction may be treated as a qualified residence for a period of up to 24 months as long as it becomes a qualified residence as soon as it is ready for occupancy. The 24-month period may begin any time after construction begins, so that if construction takes more than 24 months, the final 24 months before the property is ready for occupancy can be used.
Watch Out for AMT
The Alternative Minimum Tax (AMT) is an alternative method of calculating tax liability that is required to be used if it is greater than the regular method. When computing the AMT, acquisition debt interest is permitted as a deduction, but home equity debt interest is not. The interest on debt for unconventional homes such as boats and motor homes is also non-deductible even if they are your primary residence.
If you are subject to the AMT, make every effort to avoid any debt other than acquisition debt.
Your Home’s Basis
You need to begin keeping records related to your home’s basis (the amount you have spent on the property) as soon as you purchase it. Your basis is what you paid for your home originally (if you purchased it); including purchase expenses as well as improvement costs incurred while you own it. These records will be important in computing gain or loss should you decide to sell.
When computing your basis, remember to distinguish between improvements and repairs, as improvement costs add to your basis while repairs do not. An easy way to do this is to keep in mind that improvements are generally more permanent than repairs and enhance the value of your home.
Be sure to record costs of items like the following:
Soft water system
Make a note of expenses in your record even if you have doubt about whether an expense qualifies as an improvement. That way, the ultimate decision of qualification can be made later if you decide to sell.