CCH can assist you with stories, including interviews with CCH subject experts. Also, the 2006
CCH Whole Ball of Tax is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
neil.allen@wolterskluwer.com

Link to special CCH Tax Briefings on key topics from 2005:
 

• Federal Tax Reform Panel Issues Proposals to “Fix America’s Tax System”
  
  
• Katrina Emergency Tax Relief Act of 2005
  
  
• Streamlined Sales Tax Agreement Takes Effect
  
  
• Energy Tax Incentives Act of 2005
  
  
• New Circular 230 Rules of Practice
  
  
• Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
  
  
• Gulf Opportunity Zone Act of 2005
  

Home, Sweet Tax Shelter

(RIVERWOODS, ILL., January 2006) – The keys to your first home also unlock a strongbox full of tax breaks, according to CCH, a Wolters Kluwer business and a leading provider of tax and accounting law information, software and services (tax.cchgroup.com). Home ownership is often the stepping-stone to taking more than the standard deduction on Form 1040, and equity in a home often represents a family’s principal source of wealth. But a presidential commission suggests that eliminating the itemized deductions associated with home ownership could produce a tax system that was simpler and fairer for all.

“Owning a home involves many things, from physical shelter to a greater sense of participation in a community, but it is also a cornerstone of the finances of a typical middle-class family,” said John W. Roth, JD, CCH federal tax analyst.  “This makes it unlikely that proposals to tighten the tax rules for homeowners will gain popular support.”

Mortgage Interest Deduction Creates Itemizers

The home-related tax break first on most people’s mind is the deductibility of mortgage interest.  With the standard deduction at $10,000 for joint filers in 2005, the deductibility of mortgage interest is the first of a number of building blocks that can pile up to take someone into the rarified air of itemized deductions.

Mortgage interest has been deductible from the passage of the very first income tax in 1913, when interest of all sorts was allowed as a deduction. The thirty-year mortgage itself would not become common for another couple of decades. Over the years, other “personal” interest such as the interest on credit cards has become non-deductible, while home equity loans have stepped in to become a popular way to finance major expenditures and refinancings are a common way of consolidating consumer debt.

The mortgage interest deduction is capped at $1 million a year, but it covers mortgage interest on any second home as well as a “principal residence,” plus, for ordinary income purposes, up to $100,000 of interest on home equity loans.  For purposes of the alternative minimum tax (AMT), interest on home equity loans is deductible only if the loan is used to acquire, build or “substantially improve” a home.  Home equity loans used for other purposes – or a refinancing, to the extent it is greater than the original amount of the mortgage –  is not deductible for AMT purposes.

“Since most people aren’t subject to the AMT, the restrictions basically amount to a disclaimer at the end of ads for home equity loans,”  Roth noted.  “As more people become subject to the AMT, which is a distinct possibility, the limitation could become more significant.”

Other Deductions Pile On

With mortgage interest as a base, homeowners can then pile on a deduction for state and local taxes – property taxes at a minimum, but often state income taxes or, in 2004 and 2005, state and local sales taxes.

If the combination of these home-related deductions exceeds or approaches the standard deduction, homeowners then add on deductions for charitable contributions and, if they exceed certain minimums, deductions for medical expenses and miscellaneous itemized deductions, such as dues for unions or professional organizations.

“There are many people who can’t deduct their charitable contributions or state and local taxes because they don’t exceed the standard deduction.  But with mortgage interest as a base, homeowners usually become itemizers,” Roth said.

Reform Panel Questions Deductions

Of course, a multitude of itemized deductions – along with a panoply of credits and exemptions – contribute to the complexity of the current tax code and the number of lines on Form 1040 and its associated schedules.  It’s not surprising, then, that housing-related deductions came under scrutiny when a presidential panel on tax reform proposed alternatives to the current income tax system late last year.

The panel pointed out that the mortgage interest deduction itself benefits mainly those with large mortgage interest payments.  Someone who is nearing the end of a mortgage whose payments consist mainly of principal may not be able to take more than the standard deduction, even though the total of their monthly house payments, taxes, charitable contributions, etc. was identical to someone who was paying mainly interest and who could itemize.  People of modest means living where housing costs are low may never get to itemize either, even if housing costs make up a high percentage of their income.

Similarly, the deduction for state and local taxes, which the mortgage interest deduction often makes possible, tends to benefit residents of high-tax states more than residents of low-tax states, the panel observed. The objection here is that in the end, residents of low-tax states end up “subsidizing” their high-tax fellow citizens.

The panel proposed a simplified system in which taxpayers could take a 15-percent tax credit for the mortgage interest they paid on their principal residence, up to an amount determined by the average size of loans in their area.  Interest paid on a second home or a home equity loan would not qualify.  State and local taxes would not be deductible, but everyone would be able to take a deduction for charitable contributions in excess of 1 percent of their income.

 “The panel’s proposal could benefit some people who can’t itemize currently, but it could mean somewhat higher tax bills for others,” Roth observed.  “Several powerful players in the housing market, such as banks and realtors, have expressed opposition to the idea, so it will be interesting to see if the President adopts it in his legislative proposals for 2006.”

Exclusion Biggest Benefit

The biggest tax benefit from real estate probably lies in the ability to exclude a large amount of gain from income on the sale of a personal residence. Married homeowners who meet certain simple conditions can exclude $500,000 in gains on the sale of their homes from their incomes. Single taxpayers who meet the requirements can exclude $250,000.  The presidential panel recommended that this exclusion be kept intact.

Although this has been the law for several years now, many homeowners are not aware of the details and implications, according to Roth.

“Being able to exclude a large gain entirely from your income is an enormous benefit,” Roth said. “It not only means the income from the sale isn’t taxed, but the exclusion also makes it easier to qualify for certain itemized deductions and various credits and other tax breaks.”

For married people, the $500,000 exclusion applies as long as a few simple tests are met and neither person has used the exclusion in the last two years.

“The fact is, if they found the right bargain each time, a married couple can make a half-million dollar profit every two years by buying and selling their personal residence and not pay any tax on it,” Roth said. “The family home is the largest asset owned by many families, and a profitable sale of a long-time family residence is often a key to financing retirement.”

Requirements for Exclusion

To be eligible for the exclusion, a taxpayer must have owned and occupied the home for two years out of the five years leading up to the sale. The periods of ownership and use don’t have to overlap and they don’t have to be continuous. You could occupy the home for the first and last years during the five-year period, for example, and still qualify. The exclusion cannot be used more often than once every two years.

If someone becomes incapacitated but has lived in his home for one year during the five years before the sale, he also can count time he spent in a licensed facility (such as a nursing home) for the purpose of meeting the two-year test.

Widows and widowers can claim the full $500,000 exemption (versus the individual filer’s $250,000) if they sell the home in the same year that their spouse dies.

One Home at a Time

The exclusion applies only to a principal residence, but with a little time and a little planning, a couple with two homes might be able to use the exclusion for both.

“Suppose a couple owns a principal residence in Chicago and a winter home in Florida. In June of 2006, they sell their Chicago home, realizing less than $500,000 in gains and paying no tax on the sale,” Roth said. “After living most of the time in their Florida home for the next two years, they decide to move to an apartment, rather than maintain their single-family residence. In August of 2008, they sell the Florida home for a gain of $400,000, again excluded from income.”

A short-term or seasonal absence does not disqualify a home as a principal residence. It’s also important to note that something other than the traditional single-family home can qualify. Thus, a houseboat, mobile home, cooperative apartment or condominium that you own may be your principal home.

Few Downsides

In addition to the exclusion, homeowners usually qualify to reduce their tax bill by itemized deductions for the mortgage interest and property taxes they pay. With so many pluses, it’s hard to see the disadvantages to home ownership, but in fact there are a few.

One is that property taxes are one of the preference items that can subject you to the AMT. Also, some home-related interest that’s deductible for regular tax purposes is not deductible for AMT purposes.

It’s unlikely, however, that a homeowner would pay more tax due to the AMT than a renter with otherwise similar finances would.

Another difficulty arises if you have to sell a home for a loss. The loss is considered personal, and non-deductible, under the tax code.

“This might be one situation in which you wish you had invested your down payment in the stock market instead,” Roth said. “You can at least write off some of your losses if you make a bad investment there.”

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (tax.cchgroup.com) is a leading provider of tax, audit and accounting information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research NetWork™, Accounting Research Manager™ and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading multinational publisher and information services company. Wolters Kluwer has annual revenues (2004) of €3.3 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands (www.wolterskluwer.com). Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices.

-- ### --

nb-06-16