2008 CCH Whole Ball of Tax

Home, Sweet Tax Shelter

(RIVERWOODS, ILL., January 2008) – 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, accounting and audit information, software and services ( 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, even with home prices currently stagnant or sagging.

“Owning a home provides 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, LLM, CCH Senior Federal Tax Analyst.

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 $10,700 for joint filers on 2007 returns, 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 30-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 2007 through 2010, mortgage insurance premiums are also deductible as mortgage interest. However, the mortgage insurance had to be originally acquired on or after January 1, 2007. 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 usually either state income taxes or state and local sales taxes, as well.

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,” said Roth.

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.

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.

For 2007 returns, 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. Beginning with 2008, they will have two years after the death of their spouse in which to take advantage of the larger exclusion.

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 would a renter with otherwise similar finances.

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.”

Help for Troubled Borrowers

One other potential downside is that if mortgage debt is forgiven or wiped out through foreclosure and a subsequent sale, the amount can be considered income, and taxed accordingly. With this possibility dimming the hopes of overstretched borrowers who might “work out” their debt or lose their homes only to be socked with a hefty tax bill, Congress enacted legislation at the end of last year that excludes most forgiveness of debt for homeowners, at least on a temporary basis.

It excludes discharges of up to $2 million of indebtedness if the debt is secured by a principal residence and if it was incurred in the acquisition, construction or substantial improvement of the principal residence. This special relief is temporary and is available for three years, retroactively applied for discharges from January 1, 2007, through December 31, 2009.

Forgiveness of debt on vacation or other second homes or on home equity debt will still count as income. In addition, homeowners who took advantage of the run-up in real estate prices to refinance their mortgages can only take advantage of the new law for higher mortgage debt that was used to improve the home. “Cash out” refinancings that went for other purchases or to pay off credit-card debt don’t qualify for the exclusion if they are forgiven.

Taxpayers who take advantage of this new provision will have to reduce their “basis” in their homes by the amount excluded. For example, someone who paid $300,000 for their home and had $20,000 in mortgage debt forgiven will figure that their “basis” in their home is now $280,000. If they later sell their home for $350,000, their gain will be $70,000 rather than $50,000.

“Still, that’s a small price to pay for being able to straighten out your finances and keep your home,” Roth said.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit 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, CorpSystem™, 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 global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, and legal and regulatory sectors. Wolters Kluwer had 2006 annual revenues of €3.4 billion, employs approximately 18,450 people worldwide, and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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