Most home buyers have heard about the new rules for deducting interest on their acquisition or improvement mortgage up to $1 million (or existing home mortgages as of Oct. 13, 1987) plus up to $100,000 of home equity debt secured by the residence.
But there are additional tax deductions for homeowners and real estate investors that are often overlooked.
The so-called 1986 Tax Reform Act greatly restricted interest deductions for consumers. Interest for debt such as auto loans, credit cards and unsecured personal loans will not be deductible after 1990.
However, interest on loans secured by a primary and second residence remains fully deductible (subject to the $1 million and $100,000 limits). As a result, smart consumers are switching away from consumer loans to residence mortgages, even if the money is used elsewhere, such as to buy a car.
Although most homeowners deduct their residence mortgage interest, they often forget the hidden tax breaks. Here are the most frequently overlooked deductions:
1--Loan fees. When a new home mortgage is obtained or an existing loan is assumed by a home buyer, the lender often charges a loan fee. This charge is frequently called "points." One point equals 1% of the amount borrowed. For example, a one point loan fee to obtain a $100,000 mortgage is $1,000.
Loan fees paid to obtain a home loan qualify as deductible itemized interest in the year paid if the loan is used to buy or improve the owner's residence and if payment is made directly to the lender. The IRS says the loan fee must be paid by separate check to the lender rather than subtracted from the loan proceeds.
However, IRS Revenue Ruling 86-68 says loan fees paid to refinance an existing mortgage are not immediately fully deductible and only can be deducted over the life of the mortgage.
To illustrate, if you pay a $1,000 fee to obtain a 30-year mortgage to refinance your existing home loan, you get a $33.33 annual interest deduction for the next 30 years.
Special rules apply to FHA and VA loan costs. The origination fee paid by the borrower to obtain a VA home loan does not qualify as a deductible loan fee. But FHA loan discount charges paid by the borrower are now considered a deductible loan fee, if the FHA borrower pays the fee by separate check to the lender.
However, home sellers who pay VA or FHA loan discount fees to the lender for the buyer can subtract such charges as a sales expense.
2--An often overlooked real estate tax deduction occurs when a home buyer assumes or purchases subject to an existing mortgage such as an assumable FHA or VA loan.
The mortgage interest for the month of acquisition is usually prorated between the buyer and seller by the escrow closing settlement agent. Buyers and sellers are entitled to deduct their share of the pro-rated interest, usually hundreds of dollars.
3--Many homeowners do not own the land on which their home is located and they pay ground rent to the landowner. This land rent is tax-deductible as itemized interest if the lease exceeds 15 years, including renewal periods, and is freely assignable; there is a present or future right to buy the land, and the landlord's interest in the land is primarily a security interest (like a mortgage). However, payments to buy the land are not deductible.
4--Real estate taxes qualify as itemized deductions in the year of payment. For example, many homeowners prepaid their property taxes to the local tax collector by the end of 1989 although they could have waited until 1990 to pay the tax. However, most tax collectors will not accept more than one year of prepaid property taxes.
In addition to property tax deductions for local real estate taxes paid, if you bought a home or other real estate in 1989, don't forget to deduct your share of the pro-rated real estate tax even if it was actually paid by the seller. Each owner's pro-rated share of the property tax is deductible according to the number of days in the fiscal year the property was owned.
5--Millions of homeowners pay one-twelfth of their property taxes each month to their lender along with their mortgage payments. The escrow impound payments to the mortgage lender are not immediately deductible when paid, but they become deductible when the lender remits payment to the local tax collector.
Of course, the fire insurance portion of escrow impound payments is not deductible if the property is the owner's personal residence.
6--Most real estate sales involve various recording, title and transfer charges. These fees are not tax-deductible. However, if they were paid by the property buyer, they should be added to the buyer's cost basis for the property. If these charges were paid by the seller, they are sales expenses which should be subtracted from the gross sales price.
7--Any local property taxes and assessments are implemented for special purposes, such as new sidewalks, streets and sewers. These assessments, which benefit specific properties, are not deductible as real estate taxes. Instead, they should be capitalized and added to the property's adjusted cost basis.