Category: finance

Deducting mortgage interest, as well as interest on home equity loans and HELOCs, can save money on taxes.

Deducting mortgage interest is a great tax benefit that can make home ownership more affordable. Your first mortgage isn’t the only loan that qualifies, either. In many cases, you can also deduct interest on home equity loans, second mortgages, and home equity lines of credit, or HELOCs.

You need to itemize your return to reap the benefits of these deductions. Calculations can be complicated, so consult a tax adviser.

Know your loan limits

A good place to check out what you can deduct before you borrow is the chart on page 3 of IRS Publication 936. It’ll walk you through the requirements you must meet to deduct all of your home loan interest.

The first hurdle you’ll run into is the total amount of your loan or loans. In general, individuals and couples filing jointly can deduct interest on loans up to $1 million ($500,000 if you’re married and filing separately). The money must have been used for acquisition costs — that is the cost to buy, build, or substantially improve a home, explains Scott O’Sullivan, a certified public accountant with Margolin, Winer & Evens in Garden City, N.Y. Any interest paid on loan amounts above the $1 million threshold isn’t deductible.

The same $1 million limit applies whether you have one home or two. Buying a vacation home doesn’t double your loan limits. And two homes is the max; you can’t deduct a mortgage for a third home. If you have a mortgage you took out before Oct. 13, 1987, you have fewer restrictions on claiming a full deduction. The calculations for “grandfathered debt” can get complex, so get help from a tax professional or refer to IRS Publication 936.

Whatever you do, don’t forget that you can also deduct the points and fees associated with a first or second mortgage when you initially buy your home, says Jeff Rattiner, a CPA with JR Financial Group in Centennial, Colo. If you refinance the same house, you have to deduct those costs over the entire term of the loan. If you refinance again, you can deduct all the costs from the earlier refi in the year you take out the new loan.

Spend loan proceeds wisely

The other limitation comes into play when you take out a home equity loan or HELOC, even if you don’t use the proceeds to buy, build, or improve your home. In that case, you can deduct interest on up to $100,000 ($50,000 if married filing separately) on outstanding home equity debt. This loan limit also applies in a cash-out refi, in which you refinance and take out part of the equity you’ve built up as cash, says John R. Lieberman, a CPA with Perelson Weiner in New York City.

That means if you decide to take out a $115,000 home equity loan to buy that Porsche, you can deduct the interest on the first $100,000 but not on the $15,000 that exceeds the limit. Use the same $115,000 to add a new bedroom, however, and the full amount is allowable under the $1 million cap. Keep in mind, though, that the $115,000 gets added into the pot of whatever else you owe on your other home loans. In many cases, points and loan origination costs for HELOCs are deductible.

Consider this simplified scenario: You borrow $250,000 against your home at 8% interest. That means you’ll pay $20,000 in interest the first year. Spend the $250,000 on home improvements, and all of the interest is deductible. Spend $150,000 on improvements and $100,000 on your kids’ college tuition, and all the interest is still deductible.

But spend $100,000 on improvements and $150,000 on tuition, and the improvement outlays are deductible, though $50,000 of the tuition expense isn’t. That’ll cost you $4,000 in interest deductions. Preserve the $4,000 deduction by coming up with the extra money for tuition from another source, perhaps a low-interest student loan or by borrowing from a retirement plan. For someone in a 25% bracket, a $4,000 deduction lowers taxes by $1,000, plus applicable state income taxes.

Beware the dreaded AMT

Even if you’ve followed all the loan limit rules, you can still get stuck paying tax on mortgage interest. How come? It’s all thanks to the Alternative Minimum Tax. Congress created the AMT, which limits or eliminates many deductions, as a way to keep the wealthy from dodging their fair share of taxes.

Calculating the AMT can be complex, but if you make more than $75,000 and have several kids or other deductions, you might well be subject to it. Problem is, if you fall into the AMT group, you may not be able to deduct interest on a home equity loan, even if the loan falls within the $1 million/$100,000 limit. If you’re subject to the AMT and borrow money against the value of your home, you’ll have to use it to buy, build, or improve your place, or you may not have a chance to deduct the interest, says Rattiner, the Colorado CPA.

This article provides general information about tax laws and consequences, but shouldn’t be relied upon as tax or legal advice applicable to particular transactions or circumstances. Consult a tax professional for such advice.

If you can accept tradeoffs, real estate makes a great retirement plan: Put a rental property into an IRA, play by IRS rules, and grow your investment tax-free until retirement.

When you put a rental property (a house, condo, land, or even commercial property) in an IRA, you don’t owe taxes on the income it earns while your retirement account grows. Here’s how it works:

• You use $100,000 that’s already in an IRA account to buy a rental home. (In this example, we’re assuming for simplicity this is the full price. You can get a mortgage for real estate inside an IRA, but there are special rules. More on that later.)

• The rent is $500 a month. Every year, your investment property earns $6,000 less expenses of $3,000, netting you $3,000 per year.

• You keep that $3,000 inside your real estate IRA each year. Prudent, conventional investments allow it to grow at about 3% a year.

• In 20 years, you turn 59½ and can start taking money out of your IRA.

• You’ll have about $82,000 in your investment account (compounding $250 per month for 20 years) and the house will be worth about $180,000 (assuming home prices rise 3% a year and you never raise the rent).

Pretty sweet.

3 IRA Real Estate Rules of Thumb

Just like a traditional IRA, you have to follow the IRS rules about what you can and can’t do with it. Since it’s easier to accidentally break the rules than if you just have stocks or mutual funds, and the IRS hasn’t given a lot of guidance, work with a qualified financial adviser, CPA, or attorney who specializes in tax issues.

As you sift through the details, keep three rules of thumb in mind and you’ll be fine:

1. Everything in the IRA stays in the IRA. The real estate, and any income it generates, stays inside the IRA — at least until you turn 59½, when you can legally start taking out money.

2. Everything outside the IRA stays outside the IRA. No money from accounts other than this IRA can be used to buy or improve IRA-held real estate, or pay the property’s mortgages, taxes, and insurance.

3. You’re always one step removed from your IRA real estate. You can’t live in it. Do it and the IRS says, “Hey, you’re enjoying your retirement account before you retire.” That’s like pulling cash out of your IRA before you reach the magic age of 59½. And that means penalties. Also, only non-related contractors can work on it, and they must be paid with IRA cash. Likewise, if you sell the property before you turn 59½, keep the money in the IRA or you’ll pay penalties and taxes for early withdrawal.

The Downsides

1. Say good-bye to typical home tax deductions. Your house is already inside a tax-advantaged account, so you don’t get to deduct the mortgage interest or other expenses. If you pay cash for the property, that’s no big deal. But if you have a mortgage, mortgage interest is a big deduction to lose.

2. What if your property doesn’t generate a profit every year — perhaps the tenant is late on payments or the property is vacant for periods of time? You’ll need a cushion in your account to draw on.

3. You can’t deduct losses, such as from storms, because the property is in an IRA. Similarly, if the property is sold for a loss, you can’t deduct that. And when you take money out of the real estate IRA, it’s taxed as income. But when you own the property outright and sell it, the profit comes under the rules for cap gains, which means your profit is likely excluded from tax.

More Fine Print

Get a custodian. The companies that run typical IRAs avoid exotica like real estate. You’ll need a specialized company to help run a “self-directed” IRA where you put your rental property. Self-directed means you take more responsibility for your investment than you would typically. Here are a few custodians that let you expand into self-directed options like real estate, in addition to typical IRA investments.

• Equity Trust

• Pensco

• Provident

• Sterling

The self-directed IRA isn’t a different animal, really. All the advantages and rules of a traditional IRA apply. And since you’ll need IRA cash to manage your IRA real estate, it’s much simpler (although not legally mandatory) for you to have all IRA holdings — real estate, money market, stocks, mutual funds — with one custodian in a single self-directed account.

Costs are comparable to a traditional IRA, but as with any investments, fees can vary, as can charges for services. It pays to shop around — ask potential custodians for free breakdowns.

Pay for upkeep out of the real estate IRA.

Repairs: If your rental isn’t making enough money to cover repair costs like leaky faucets or broken furnaces, tough luck. You can’t pay for the repairs out of your own pocket.

Upgrades: A DIY upgrade is verboten because you’re contributing something of value (your labor) to the IRA, says Kevin Worthley, a financial planner who specializes in retirement planning. Still, if you personally fix a faulty electrical outlet, for example, you could argue that you aren’t adding to the house’s value, merely maintaining it, so that should pass muster with the IRS.

So does that mean you can never fix up your IRA house? You can turn it into a palace if you want — but you can’t do it yourself. Hire contractors, and pay all their fees from inside the IRA. If you have $1 million inside your IRA, go right ahead and buy a $500,000 house and spend $250,000 to improve it, leaving yourself a plentiful cushion. But you can’t spend one dime out of your regular income or personally do anything more elaborate than change a washer in the faucet.

Solution: Keep a cash cushion in your real estate IRA to cover unexpected repairs and vacancies. How much? Think of what you do for your primary residence and match it for your rental. Make a list of the costs of your rental taxes, mortgage, and upkeep if you have to go for an extended period without a tenant.

Get a special real estate IRA mortgage. If you’re not planning to buy a rental property outright with existing IRA funds, you’ll need a non-recourse loan. That literally means the bank has no (or virtually no) recourse if you default. If you stop making payments on a non-recourse loan because your IRA runs out of cash, the bank can’t force you to pay the mortgage with non-IRA money. (That would break the law by commingling regular funds with IRA funds.)

Since a non-recourse loan is a bigger risk for a bank, it will want a 30% or larger down payment (from your IRA account, not your personal bank account), and you’re going to pay a higher interest rate by several points than you would for your regular home loan.

Other than that, the mortgage works like any other:

• Instruct your custodian to draw checks from cash inside your IRA to the bank.

• Or have the custodian set up a regular electronic transfer. The custodian will also do this for real estate taxes and insurance.

As long as the IRS sees that all home-related payments come out of the IRA account, you’re fine.

So What Happens When I Retire?

At 70½, you must start taking a certain minimum out of your IRA regularly, so you need enough cash on hand to pay yourself. Make sure you have this cushion well before you hit 70½. You can also sell the IRA house and put the cash into a more liquid investment.

Here’s another option: When you turn 59½, you can legally take your house out of your IRA. The investment that generated tax-free income all these years is now your cozy retirement cottage. Of course, you have to pay income tax on the home’s value, but if you sold your primary house, you now have the cash to do that, so you’re set for your golden years.

Or, at 59 1/2 you can create a series of deeds that gradually transfer your house to you personally while leaving some of it in your IRA, before you actually move in. This stretches out your income tax liabilities because you’re basically taking only a piece of your house out of the IRA each year. You need a lawyer and title company to do this, but if you want to avoid a large tax bill in your first residence year, it’s worth it.

This article provides general information about tax laws and consequences, but shouldn’t be relied upon as tax or legal advice applicable to particular transactions or circumstances. Consult a tax professional for such advice.

Whether a first-time buyer or a longtime owner, you may be eligible for a homebuyer tax credit if you meet IRS guidelines.

Some first-time buyers and longtime owners may be able to claim a federal homebuyer tax credit on a principal residence bought in 2009 or early 2010. Eligibility depends on a number of factors, including income, homeownership status, and the exact purchase date of the home.

To be considered a first-time buyer by the IRS, you mustn’t have owned a home for the three years prior to your purchase. Longtime owners must’ve lived in their homes for five consecutive years during the past eight years. Revised rules apply to those who buy between Nov. 7, 2009, and April 30, 2010. Buyers who made purchases on or before Nov. 6, 2009, are covered under an older set of guidelines.

New rules for first-time homebuyers

First-time buyers who purchase a home between Nov. 7, 2009, and April 30, 2010, may be entitled to a federal tax credit worth 10% of the sale price or $8,000, whichever is lesser. Income restrictions apply. The tax credit for joint filers begins to phase out at a modified adjusted gross income of $225,000 ($125,000 for individual taxpayers). The credit disappears entirely at $245,000 for joint filers ($145,000 for individuals).

While first-time buyers must enter into a binding contract to purchase a principal residence by April 30, the closing can take place as late as Sept. 30, 2010. The home can’t cost more than $800,000.

Qualifying purchases in 2009 can be claimed on your 2008 or 2009 return. File an amended return for 2008. Purchases in 2010 can be claimed on your 2009 or 2010 return. To get the credit for the 2009 tax year on a purchase that closes after April 15, 2010, either request an automatic filing extension or file an amended 2009 return.

The first-time homebuyer tax credit is “refundable,” according to Ken Burstiner, a CPA at Weiser LLP in New York City. That means you can earn it even if you owe no federal tax, the credit exceeds your total tax liability, or you have little income. Claim the credit on IRS Form 5405, which should take less than an hour to fill out. It’s a good idea to consult a tax adviser. H&R Block’s average fee to prepare a tax return is $187.

Old rules for first-time homebuyers

First-timers who bought a home between Jan. 1, 2009, and Nov. 6, 2009, may also be eligible for a federal tax credit worth up to $8,000. A tax credit reduces your tax bill or increases your refund dollar for dollar. In general, whether under the old rules or the new rules, you’ll be required to repay the full value of the credit to the IRS if you don’t maintain the home as your principal residence for three years.

First-time buyers subject to the old rules face tighter income limit. The phase-out kicks in for joint filers when modified adjusted gross income hits $150,000 ($75,000 for individual taxpayers). It disappears entirely at $170,000 for joint filers ($95,000 for individuals). Married filing separately taxpayers can claim only up to half of the $8,000 credit.

First-time buyers in 2008 were subject to a different tax-credit program. Homes purchased after April 8, 2008, and before Jan. 1, 2009, were eligible for a credit worth the lesser of $7,500 or 10% of the home’s purchase price. Income limits and phase-out ranges were the same as those for first-time buyers between Jan. 1, 2009, and Nov. 6, 2009.

The biggest difference between 2008 and 2009 was that the tax credit in 2008 really functioned as an interest-free loan that must be paid back over 15 years. The first of the annual installments should come due on the 2010 tax return filed in 2011. With few exceptions, if your home ceases to be your main residence during those 15 years, you have to pay back the outstanding amount with the subsequent tax return.

Tax credit for longtime homeowners

If you’re a longtime homeowner–meaning you’ve lived at your principal residence for five consecutive years out of the last eight–you may qualify for a homebuyer tax credit worth up to $6,500. You must purchase a new principal residence between Nov. 7, 2009, and April 30, 2010. Like the first-time homebuyer tax credit that applies to these dates, you can settle as late as Sept. 30, 2010, as long as you have a binding contract by April 30.

The same $800,000 cap on the purchase price applies to longtime homeowners, as do the same income restrictions. The credit begins to phase out for joint filers at modified adjusted gross income of $225,000 ($125,000 for individuals), and disappears at $245,000 ($145,000 for individuals). Married couples filing separately are eligible for up to half of the $6,500 credit.

For both first-time and longtime buyers who want to claim the tax credit for a purchase made after Nov. 6, 2009, the IRS requires proof. Attach a copy of the settlement statement you received at closing to your return. You must be at least 18 years old.

Other restrictions and provisions

As long as they serve as principal residences, single-family homes, townhouses, co-ops, and condos are all eligible for a tax credit. Mobile homes may be eligible for the credit, even if the land itself is leased. Owning a vacation home or rental property doesn’t disqualify you as a first-time homebuyer, but you do have to make it clear such properties were never your principal residence.

You won’t be eligible for the tax credit if you’re buying from a close relative. For example, if your mother goes into a nursing home and you buy her house from her, you can’t claim the credit. Close relatives include parents, grandparents, children, grandchildren, your spouse, and your spouse’s family.

This article provides general information about tax laws and consequences, but is not intended to be relied upon by readers as tax or legal advice applicable to particular transactions or circumstances. Readers should consult a tax professional for such advice, and are reminded that tax laws may vary by jurisdiction.