2006 CCH Whole Ball of Tax
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.
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