Home ownership has been the American dream. Over the years, Congress has enacted tax laws that encouraged the American taxpayer to own a home.
Laws such as the "principal residence roll-over rule" and the "once-in-a-lifetime, over-55 exemption" have been significant tax breaks for many years. Many analysts have credited these tax laws in part for the rapid appreciation of real estate that took place during the past 20 years.
For example, suppose you bought your first house many years ago, and the house has appreciated significantly. While it was growing in value, you were entitled to deduct mortgage interest and real estate tax payments.
When you sold your house and purchased another principal residence within two years, if your new house was at least as expensive as your old house, you were entitled to "roll over" your profits without paying tax on this gain.
Then, when you reached 55, if you had lived in the house three out of the last five years, the first $125,000 of gain upon sale of your house was exempt from income tax.
Thus, Congress was encouraging people to own homes, move up to more expensive ones and be assured of a tax-free cushion as they moved into their later years. In 1986, however, when Congress enacted major tax reform, a new philosophy toward home ownership began to be heard on Capitol Hill. Legislators grew concerned about differentiating between ownership and renting, and also significantly reduced the value of the various real estate deductions.
However, the basic homeowner deductions still have not been affected, and this series will discuss some basic tax rules for real estate owners and investors.
Today's column will provide a preliminary list of deductions available to the average homeowner. As a homeowner, you may deduct the following expenses:
Mortgage interest. At the end of each year, your mortgage lender will provide a statement indicating how much interest you paid during the past year and what the current principal balance is on your mortgage.
If property taxes are escrowed by the lender, the statement will also indicate the amount of real estate tax paid.
Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million and home-equity loans up to $100,000.
If you are married and file separately, the limits are $500,000 for acquisition loans and $50,000 for home-equity loans.
Keep in mind that Congress used the words acquisition loans. To qualify for such a loan, you must buy, construct or substantially improve your home. If you obtain a refinance loan for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan. However, it may qualify as a home-equity loan.
Several years ago, you purchased your house for $100,000 and obtained a mortgage (or deed of trust) of $80,000. Last year, your mortgage indebtedness had been reduced to $75,000, but your house was worth $200,000.
You refinanced and obtained a new mortgage of $150,000. The acquisition indebtedness is $75,000. The additional $75,000 that you pulled out does not qualify as acquisition debt, but since it is under $100,000, it qualifies as a home-equity loan.
The IRS has ruled that you do not have to take out a separate home-equity loan to qualify for this aspect of the tax deduction.
However, if you had borrowed $200,000, you would only be able to deduct interest on $175,000 of your loan--the $75,000 acquisition indebtedness plus the $100,000 home equity.
The remaining interest is treated as personal interest. For 1990, only 10% of the interest on the excess is deductible. In 1991, none of the remaining interest is deductible.
Keep in mind that although Congress has been making changes in the interest-deduction structure since 1986, for all practical purposes, a home-equity loan can be obtained for any purpose whatever. You no longer have to justify your loan as meeting certain educational or medical requirements, as was the case in 1987.
Points. These are also called "loan origination fees," "premium charges" or "discounts." Points are deductible in full in the year of payment, provided that the amount of the points is consistent with lending practices in the locale in which the house is bought.
Although the IRS recently ruled that effective Jan. 1, 1991, points do not have to be paid separately, for tax year 1990, it would have been advisable if you had paid points to write a separate check to the lender or the escrow company to reflect that these points were separately paid.
Points paid to obtain a refinance mortgage may or may not be deductible. If you make substantial improvements to your house and refinance for the purpose of covering these improvements, then the points would be deductible.
However, if you are merely changing one interest rate loan for another, or pulling out new money from your house, the points are not deductible in full, but rather have to be allocated over the life of the loan.