As Federal Govenment Contemplates Tax Changes, Make Sure You Understand The Current Rules
January 7, 2006, By Benny Kass Washington Post

Tax considerations have long been an important part of homeownership in the United States. In November, a presidential tax advisory panel issued a report calling for a number of tax changes, including several that would affect homeowners and real estate investors.

The biggest change the panel called for was replacing the deduction for mortgage interest with what it called a home credit. This credit would be equal to 15 percent of the mortgage interest paid by a taxpayer on a loan that was secured by the taxpayer's principal residence, and used to acquire, construct, or substantially improve that residence. The President's Advisory Panel on Federal Tax Reform also recommended the elimination of the deduction for mortgage interest on second homes and on home-equity loans.

According to the final report of the panel: "The home credit would encourage homeownership, not big homes. More Americans would be able to take advantage of tax benefits for owning a home, while the current subsidy for luxury and vacation homes would be curtailed. In addition, the home credit would reduce the incentive to take on more debt by eliminating the deduction for interest on home equity loans."

Will Congress enact any of the panel's recommendations this year? Perhaps, but the great majority likely will be stalled by lobbyists and by the Congressional elections coming in November -- as well as other priorities such as paying for Iraq and for aid to victims of Hurricane Katrina.

What is certain, however, is that tax time is here again. This year, April 15 falls on a Saturday, so all income tax returns must be postmarked by midnight, Monday, April 17.

Over the next several weeks, I will be writing a series of articles that aim to help real estate owners understand tax law, to take advantage of every benefit available. This week, I will provide an overview; in the following weeks, I will cover specific issues in more detail.

This year, the IRS has given taxpayers a new break. Instead of the four-month automatic extension, you can now opt for a six-month automatic extension by filing application form 4868.

According to an IRS press release: "The new regulations provide streamlined and simplified procedures that are expected to save taxpayers between $73 million and $94 million, annually, by eliminating or consolidating several existing IRS forms. As a result, beginning Jan. 1, 2006, most individuals and businesses will be able to request a full six- month tax-filing extension, without a reason or even a signature.

"The new procedures will replace the existing two-step process under which noncorporate taxpayers could only get a six-month extension by first obtaining an extension, usually automatic, for part of that period and then requesting a discretionary extension for the remainder. A tax-filing extension does not extend the tax-payment deadline."

The last sentence is extremely important. Even if you get an extension to file your tax return until Oct. 15, you must still pay the tax you owe by the original due date, April 17.

Our tax laws are complex. According to the presidential advisory panel, "We have lost sight of the fact that the fundamental purpose of our tax system is to raise revenues to fund government." Since the enactment of the income tax in 1913, the tax code has been used by Congress to favor certain constituencies, and is replete with exemptions, exclusions and other benefits for individuals and corporations.

Among those are the tax breaks available to most homeowners. If you are in a 31 percent tax bracket, each dollar you deduct will save you 31 cents in federal taxes. Here are the major itemized tax deductions for homeowners:
As Federal Government Contemplates Tax Changes, Make Sure You Understand the Current Rules
Mortgage interest. Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. (If you are married, but file separately, the limits are split in half.)

The concept of an acquisition loan is important, and it has confused many homeowners. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all the excess to improve your home. However, any other excess may qualify as a home equity loan.

For example, say you purchased a house several years ago for $180,000 and obtained a mortgage (or deed of trust) for $130,000. Last year, your mortgage indebtedness had been reduced to $120,000, but because of the hot real estate market, the value of your home had increased dramatically, to $300,000.

Because you wanted to pull out some cash from the equity in your home, you refinanced and got a new mortgage of $200,000. For tax purposes, your acquisition indebtedness is $120,000 (i.e., the amount of your existing loan). The additional $80,000 that you took out of your equity does not qualify as acquisition indebtedness. However, since it is less than $100,000, it qualifies as a home equity loan with deductible interest. (Several years ago, the Internal Revenue Service ruled that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction.)

However, if you had borrowed $225,000, you would be able to deduct interest on only $220,000 of your loan -- the $120,000 acquisition indebtedness, plus the $100,000 allowable home equity.

The remaining interest is treated as personal interest, and is not deductible.

You should also note that for all practical purposes, there are no tax restrictions on the use of the money obtained from a home equity loan. You no longer have to justify your loan as meeting certain educational or medical requirements.

Taxes. Property taxes, both state and local, can be deducted. However, real estate taxes are deductible only in the year they are actually paid to the government. Thus, if last year you escrowed money with your lender for taxes to be paid in 2006, you cannot take a deduction for these taxes when you file your 2005 return.

However, if you bought a house last year, you may have reimbursed your seller for a portion of the prepaid taxes through the end of 2005. Review your settlement sheet carefully. Line 106 on page 1 of that statement should reflect this tax adjustment. Because this was a current payment by you for real estate taxes, it is deductible.

However, when you receive your annual statement from your lender showing the amount of taxes paid last year, that may not be included in that statement. Lenders are required to send these annual statements to borrowers by the end of January of each year, reflecting interest and taxes paid for the previous year.

Points. When you obtain a mortgage loan, you often have to pay one or more points to get that loan. Whether referred to as "loan origination fees," "premium charges," or "discounts," they are still points. Each point is one percent of the amount borrowed; if you obtain a loan of $250,000, each point will cost you $2,500. Points are deductible, but there are some complications.