Link to special CCH Tax Briefings on key topics from 2003:
 

• Year-End Tax Legislation Update (Dec. 10)
• Corporate Income Tax and 'Bonus' Depreciation
  (Dec. 4)
• Military Family Tax Relief Act (Nov. 11)
• Jobs and Growth Tax Relief Reconciliation Act of 2003 (May 28)

CCH can assist you with stories, including interviews with CCH subject experts. Also, the CCH Whole Ball of Tax 2004 is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

For Many, Home Sale Exclusion is Biggest Tax Break

(RIVERWOODS, ILL., January 2004) – For decades, Americans have been advised that the tax laws favor owning a home, rather than renting, because tax deductions lower the cost of ownership. While that’s still the case for many people, their biggest tax advantage may not lie in taking housing-related deductions. Instead, they may profit the most by using a home as a tax-free investment, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software.

"The standard deduction for married couples filing jointly is $9,500 for 2003 returns and will rise to $9,700 for the 2004 tax year. Some homeowners with small mortgages at low interest rates and who pay modest taxes may find that they gain little additional tax savings through itemizing," said John W. Roth, JD, federal tax analyst for CCH. For homeowners with bigger incomes, and potentially bigger deductions, another potential pitfall looms: the alternative minimum tax, or AMT.

"Large deductions for state taxes can expose a taxpayer to AMT, and so can deductions for interest on home equity loans and lines of credit," Roth noted. "In addition, high-income taxpayers can lose up to 80 percent of their itemized deductions."

Deductions Still Help Many

For a substantial number of people, however, the deductions related to home ownership continue to be important. In 2001, the latest year for which figures are available, nearly 37 million taxpayers claimed the interest deduction, and it subtracted more from their taxable incomes than any other type of itemized deduction – a little over $340 billion. Nearly 44 million returns showed a deduction for taxes paid, which includes state income tax as well as property tax, and this shaved over $304 billion from their taxable incomes.

Mortgage interest is deductible on mortgages of up to $1 million for the homeowner’s residence and a second home. In the case of a second home, though, the homeowner must either not rent it out at all or else live in it personally for at least 14 days a year or 10 percent of the days it is rented at a fair market value – whichever is greater.

Homeowners also can deduct the interest on home equity loans of up to $100,000 or the difference between the balance of their mortgage and the fair market value of their homes, whichever is less.

Home equity loans can expose borrowers to the AMT, however. Home equity loans used for anything other than home improvements are not deductible in the calculations used to arrive at the income figure used in determining AMT liability.

"That doesn’t mean you’ll automatically owe the alternative tax, but it does mean you probably need to run the AMT calculations to be sure," said Roth. "With regular taxes falling, AMT is looming larger on many taxpayers’ horizons."

Points and Refinancings

With the flurry of refinancings in 2003, many itemizers may have additional opportunities if they itemize. Although points paid with the original mortgage can generally be deducted in full, points paid at refinancings can’t be deducted all at once, but instead are deducted over the life of the loan. For example, $6,000 in points paid to refinance a 20-year mortgage would lead to an interest deduction of $300 per year.

But if you paid points on your first refinancing of your mortgage and then refinanced a second time, all of the points on the first refinancing that haven’t yet been written off become deductible. To continue the example, someone who deducted $900 out of $6,000 in points over three years and then refinanced last year could deduct the remaining $5,100 in points from the first refinancing on their 2003 return.

Repairs Usually Not Deductible

Ordinarily, you can’t deduct the cost of repairs to your home or take any deduction for depreciation, utilities or the cost of insurance. The rules change, however, if you use a portion of your home as a home office. Then, the portion of those expenses attributed to the office space can be deducted as a business expense.

There is a catch, however, if you later sell your home. Any depreciation you took must be subtracted from the gain prior to claiming the exemption amount, and it will be taxed at a rate of 25 percent.

"This provision requires homeowners to do a bit more homework to decide whether the home-office deduction is worth it, given the tax they’ll have to pay when they go to sell their home," said Roth. "That’s after they make sure that they meet all the requirements for taking the home-office deduction in the first place."

Exclusion is Biggest Break

Since 1997, the biggest tax benefit from owning real estate has been 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.

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

"This is likely to be the single biggest source of tax-free income available to the average taxpayer," Roth said. "In addition, excluding the gain on the sale of a home keeps tax rates lower on your other income and makes it easier to qualify for certain itemized deductions, various credits and other tax breaks."

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

"If they planned correctly and 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 the time he spent in a licensed facility (such as a nursing home) for the purpose of meeting the two-year test. This year, Congress granted members of the military the ability to claim the exclusion by excluding up to ten years of active duty away from home in calculating their eligibility.

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.

Reduced Exclusion for Qualified Hardships

People qualify for hardship relief and are entitled to a reduced, pro-rata exclusion if a change in employment, health or unforeseen circumstances keep them from meeting the two-year ownership requirement. This year, the IRS spelled out that unforeseen circumstances included death, loss of a job, divorce or legal separation and multiple births from the same pregnancy, and left the door open for further refinement of this category.

One Home at a Time

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

"Suppose a couple owns a principal residence in Chicago and a winter home in Florida. In June of 2002, 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 maintaining their single-family residence. In August of 2004, they sell the Florida home for $300,000, 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

With so many pluses, it’s hard to see the disadvantages to home ownership, but in fact there are a few. Exposure to the AMT through disallowed deductions is one. Another is that homeowners get no relief if they sell their 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 INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, accounting, legal, securities and small business markets. CCH is a Wolters Kluwer company. The CCH Federal and State Tax group, CCH Tax Compliance and Aspen Publishers Tax and Accounting group comprise the new Wolters Kluwer Tax and Accounting unit. The unit’s web site can be accessed at tax.cchgroup.com.

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