With tax season in the past, it's time to think about the tax implications of decisions your clients may be making about their homes in 2014. The rules are complicated and because of the huge amounts involved, the decisions could have major repercussions. Refresh your memory on the following key home-related aspects of the IRC.
Exclusion break for home sellers. They can "exclude", meaning escape taxes on as much as $500,000 in profit for married couples filing jointly and $250,000 for those who file single returns or are married and file separate returns. Remember, that's profit, not sales price. What if the profit is greater than the exclusion amount of $250,000 or $500,000? The excess is taxed as a long-term capital gain at a maximum rate of 20 percent (23.8 percent if you're liable for the Medicare surtax), plus applicable state taxes.
The exclusion isn't a one-time opportunity; claim it as often as every two years. To qualify, you must pass two tests. First, you've owned and lived in the property as your principal residence or main home for at least two years out of the five-year period that ends on the date of sale. Second, you haven't excluded gain on another sale of a principal residence within the two years that precede the sale date.
Those two years needn't be consecutive; they can be off and on for a total of two full years. Short temporary absences for vacations or other seasonal absences count as periods of owner use. This holds true even if you rent out the property during the absences.
Principal residence. The profit exclusion isn't limited to the sale of a conventional single-family home. Your principal residence also can be a condo, a cooperative apartment, your portion of a multi-unit apartment building, a house trailer, a mobile home or anything else that provides all the amenities of a home, such as a houseboat or yacht that has facilities for cooking, sleeping and sanitation, or even a vacation retreat that you move into after retirement. Moreover, the location of the principal residence doesn't matter. It can be in a country other than the United States.
Partial exclusion. There's tax relief in the form of a partial exclusion for someone who sold another home within the previous two years or fails to satisfy the ownership and use requirements. Take advantage of the partial exclusion when the primary reason for the sale is health problems, a change in employment, or certain unforeseen circumstances. They include divorce or legal separation, or natural or man-made disasters that cause residential damage.
To illustrate, you're single, have lived in your dwelling for just 12 months and move to a new job in another city. You can exclude gain of as much as $125,000—12 months divided by 24 months, or 50 percent times $250,000.
Home improvements: Why it's important to keep track of your spending. Have you made home improvements? They yield no current deductions but are added to your home's cost basis, which is the figure used to determine gain or loss on a sale of the property. Hence, improvements reduce any taxable profit when you eventually sell.
In the event the IRS questions your sale, the audit will be less traumatic and less expensive if you've kept meticulous records that track the dwelling's basis. Those records should include what you originally paid for your property, plus settlement or closing costs, such as title insurance and legal fees, as well as what you later shell out for improvements, such as adding a room or paving a driveway. Such improvements should not be confused with routine repairs or maintenance that adds nothing to the place's value, such as painting or papering a room or replacing a broken windowpane.
Bundle ordinary repairs into a bigger job. It might pay to postpone repair projects until they can be done in connection with an extensive remodeling or restoration project. Adding the smaller jobs into the bigger job may allow you to include some items that would otherwise be considered repairs, such as the cost of painting rooms.
No marriage penalty for newlyweds. The IRS bestows a gift on newlyweds who both own homes that they sell before or after their trip down the aisle. On their joint return, each spouse can exclude as much as $250,000 of gain, provided each one could exclude up to $250,000 if they filed separately. But there the IRS draws the line. One spouse can't use any part of the others unused exclusion, so as to exclude gain of more than $250,000 per person.
Points on mortgage loans. Planning to buy a new home around year's end? Try to wrap things up by December 31.The inducement to meet that deadline is a 2014 deduction if the only way to get a mortgage is to pay points to a lending institution. Take an immediate deduction in full for upfront interest payments incurred to obtain a loan to buy, build or improve your main home (as when you add or remodel a room). This is for a "main home", as opposed to a second home that you use as a vacation retreat, or property for which you charge rent.
Different rules govern refinancings of existing mortgages. Use the loan proceeds to improve your home and you can fully deduct the points. Refinance just to take advantage of lower interest rates and you must claim points only in dribs and drabs over the loan's full term—divide what you paid for points by the number of monthly payments you will make over the life of the loan.
Borrowers who refinance for second or third times often overlook sizable write-offs. Serial refinancers can immediately deduct what remains of the points from previous refinancings. But borrowers fail to recall those points because they don't show up on the closing papers of new refinancings. Typically, several thousand dollars fall right through the cracks. For refinancers who fall into a 30 percent federal and state bracket, every $1,000 they write off lowers taxes by $300—more than enough to pay for a pleasant night on the town.
Real estate taxes. Deductions on Schedule A for real estate taxes usually mean any state, local or foreign taxes on real property. But a special rule applies when a portion of your monthly mortgage payment goes into an escrow account and your lender periodically pays your real estate taxes to local governments out of this account. The allowable deduction is the amount actually paid during the year to the taxing authorities. Your lender will normally send you a Form 1098, Mortgage Interest Statement, at the end of the tax year with this information.
About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Tax Tips for Marriage and Divorce", available for Kindle at Amazon.com and as a print copy at julianblocktaxexpert.com.
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.