For years one of the few tax benefits left for the non-business owner has been home ownership. The tax benefits are available for business owners as well, of course. You just need to own a home to get the breaks!
The two key tax breaks are:
- Deductibility of mortgage interest and property tax
- Tax-free gain exclusion upon sale
On the surface, it sounds pretty simple. But of course, just like most tax law it’s not that simple at all.
Let’s look at the standard mortgage deduction that you report on your Form Schedule A – Itemized Deductions.
Following the Mortgage Deductions Rules
In order to take a deduction for your mortgage interest, you must follow certain rules.
- The mortgage must be secured debt.That means there is a mortgage, deed of trust or land contract and you’ve put your house up as collateral.
If you have sold or purchased a home on a wraparound contract, the interest may not be deductible. (This is in spite of what you might have heard from so called real estate seminar gurus.)
Let’s say that Sally sells her house to Sam. Sally has a mortgage of $50,000. She sells the house to Sam for $100,000 for $10,000 down and then payments on the $90,000. Sally continues paying for the underlying mortgage.
If Sally doesn’t record the mortgage or somehow other ‘perfect’ the security under state law, Sam doesn’t get to take advantage of the mortgage interest deduction.
TIP: If you are buying a principal residence or second residence with a wraparound mortgage, insist on having the loan recorded in order to get the home mortgage interest deduction.
- The mortgage must be secured by a qualified home.A home could be a house, condo, boat or any other property that has sleeping, cooking and toilet facilities.
- You can have only one main home at any time.You can also have a second home. (The total indebtedness of the two must be added together to determine if they are below the maximum debt indebtedness allowed. More on that in a minute.) The second home must either not be rented out at all or if it is rented out, must meet strict use amounts.
If the second home is rented out, you must use it as a home during the year to qualify as a qualified home. Otherwise, it is considered an investment property which allows you to also deduct depreciation, but might have deductibility limitations based on passive activity rules.
In order to keep the second home deductibility, you must use the home for more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair market rent, whichever is longer. So, if you rent out your house for a weekend, you have to stay there at least 14 days. If you rent out the house for 180 days, you need to stay there at least 18 days.
Tip: If you have a second home, figure out whether you get more benefit if it’s an investment property or if it’s a second home. The investment property strategy allows more deductions, but any losses might be suspended until you sell.
- Total of all mortgage indebtedness used to buy, build or improve your property can not total more than $1,000,000. If it does, part of the interest will not be deductible.
- Total of mortgage taken out for reasons other than to buy, build or improve your home can not total more than $100,000 and can not be more than the fair market value of your home.If you’re upside down on your property (you owe more than it’s worth), you might have just lost your home equity deduction. If you have taken out a loan (through refinance or home equity line) for investments or business, then the pro-rata portion of that interest is deductible as an investment or business expense.
Tip: If you’re in an area that has had some real estate value downturn, but you still qualify for the deduction, protect yourself now! It’s very possible that the doubled IRS audit force will be coming after this deduction next. Prove the value of your property and that you still get the deduction.
- The debt must be to buy, build or substantially improve a qualified home.This part of the rules refers to ‘home acquisition’ indebtedness. As you pay down your mortgage, the amount of allowable acquisition indebtedness goes down. If you later refinance your property and receive cash out (called a cash-out refi), you will have a mortgage debt that is partially qualified and partially not. The qualified portion is equal to the paid down indebtedness from the first loan. You can also qualify the other portion if the proceeds are used to substantially improve the property.
This is just one little part of the law regarding home residences and the mortgage deductibility. Are you sure you’re getting the best advice with your real estate?
We have two solutions:
- Hire us to be your full service tax firm. We have experienced CPAs with personal real estate experience totaling over 50 years. Contact Us. today!
- Own the Real Estate Loopholes Home Study Course.