01/02/07: A Primer On Real Estate Taxation
By Benny L. Kass
(First of a Series)
“Unquestionably, there is progress. The average American now pays out twice as much in taxes as he formerly got in wages.” (H.L. Mencken).
It’s tax time again. In just 101 days from today, our income tax returns will be due. April 15th this year falls on a Sunday, so we get an extra day to procrastinate. Actually, if you live in the District of Columbia, Maryland, Maine, Massachusetts, New Hampshire, New York, or Vermont, you get one additional day until April 17th.
According to Mark Everson, the Commissioner of the Internal Revenue Service, “paying taxes is a unifying experience fundamental to democracy and the rule of law.”
In other words, to avoid penalties, interest – and possibly jail time – all American homeowners must either file their income tax return or get an extension. The law allows taxpayers to get an automatic six month extension (until October 15, 2007) but only if you file form 4868 no later than the April 16th (or 17th) due date.
In the last weeks of December, Congress enacted the Tax Relief and Health Care Act of 2006. Many of the forms which the IRS had already published have to be changed as a result of some of the provisions of this new law. To get a good read on these changes, go to www.irs.gov, and click on “What’s Hot”. So be careful to get the most recent information and the most current forms.
The IRS estimates that the average time it will take non-business taxpayers to file the 1040 form is approximately 24.2 hours. However, according to that tax agency, “the largest component of time burden for all taxpayers is record keeping, as opposed to form completion and submission.” So of the 24.2 hours referenced above, to complete the form will only take 3.3 hours, but 14.6 hours of record keeping. (IRS Publication entitled “2006 1040 Instructions.)
Good luck! You should start this afternoon, and hope that you will be ready by the due date.
Two significant home buyer tax amendments were enacted last month. The first-time home buyer exemption of up to $5000 was reinstated for District of Columbia residents, and homeowners who obtain a mortgage loan this year and are required to pay a mortgage insurance premium will be able to deduct those payments as “mortgage interest” when they file their 2007 tax return. These issues will be discussed later in this series of tax articles.
If you need assistance with your tax returns, you have several options. First choice: retain a professional tax accountant. While this will cost you some money, since tax issues are complex, the cost will be well worth it – and besides, if you itemize you can deduct the cost for this CPA.
If you are a low-income tax filer, there are independent Low Income Tax Clinics (LITCs) which will provide representation for free or for a nominal charge. IRS Publication 4134, entitled “Low Income Taxpayer Clinic List” will give you information on clinics in your area. (www.irs.gov and click on Publications.)
Additionally, within the IRS is an independent organization called the Taxpayer Advocate Service. According to the IRS, these employees “assist taxpayers who are experiencing economic harm, who are seeking help in resolving tax problems that have not been resolved through normal channels, or who believe than an IRS system or procedure is not working as it should”. (IRS Publication “2006 - 1040 Instructions, at p. 6).
You can contact the Taxpayer Advocate Service by calling them toll-free at 1-877-777-4778 or filing form 911, entitled “Application for Taxpayer Assistance Order” with the IRS. To obtain a copy of this form, and to obtain more information about the service, go to www.irs.gov/advocate.
This series of articles should assist the homeowner in understanding the real estate tax laws – both residential and investment – so that you can take advantage of every tax benefit that is available. Keep in mind that if you are in the 25 percent Federal tax bracket, for example, for every additional dollar you can legally deduct, you will be saving approximately 25 cents that does not have to go to Uncle Sam. This bracket is for married taxpayers, who file jointly and earn between $61,300 and $123,700 per year.
Our tax laws are complex, and there are a number of definitions and concepts which must be understood:
– "basis" – the initial cost of the property, plus any improvements you have made over the years.
– "gross profit" – the difference between what you originally paid for your house and the sales price.
– "net profit" – you have to subtract any improvements you have made to the property, and also any real estate commissions paid when you sold the property. The bottom line net profit is also called "capital gain."
Home ownership is still the Great American dream, and continues to be encouraged by our Federal Tax Code. Consider this typical scenario: in 1975, you bought your first home for $35,000. You and your spouse had three children, and your first home was just too small. You sold your home for $80,000, and bought another for $95,000.
Your profit -- not taking into consideration expenses, improvements, or real estate commissions -- was $45,000. But since you were then able to take advantage of a tax benefit known as the "rollover," you did not have to pay tax on these capital gains. The rollover was completely eliminated when President Clinton signed into law the Taxpayer Relief Act of 1997. As will be seen in subsequent columns, homeowners are now permitted to exclude up to $250,000 of profits made on their principal residence ($500,000 for married taxpayers filing joint returns). And this exclusion is not limited to any one sale, but can be taken every two years – so long as you meet certain eligibility criteria.
Congress also repealed the "once in a lifetime" exemption, whereby homeowners over the age of 55 were given a one-time absolute exclusion of up to $125,000 of the overall profit made on the sale of their principal residence.
Thus, the "rollover" and the "once in a lifetime" exclusion are history, having been replaced by a more simplistic – and more financially rewarding – concept: up to $500,000 of profit can be excluded every two years.
For those of us who own homes, and are preparing to file our 2006 tax returns, here is a list of the itemized tax deductions available to most homeowners:
– 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.
– Taxes. Property taxes, both state and local, can be deducted. However, it should be noted that real estate taxes are only deductible in the year they are actually paid to the government. Thus, if last year you escrowed monies with your lender for taxes to be paid in 2007, you cannot take a deduction for these taxes when you file your 2006 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 2001. Review your settlement sheet carefully. Line 106 on page 1 of that statement should reflect this tax adjustment. Since this was a current payment by you for real estate taxes, it is a deductible item. Indeed, when you receive your annual statement from your lender showing the amount of taxes paid last year, this information will 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. But in this case, you paid the real estate taxes to your seller directly, without the involvement of your mortgage lender.
– Points. Most mortgage loans in recent years did not include points. But if you paid points , you may be able to deduct them on your tax return. Some lenders call these "loan origination fees,"others call them "premium charges," or "discounts." Call them what you want, they are still points. Each point is one percent of the amount borrowed; if you obtain a loan of $275,000, each point will cost you $2,750.00. (A column later in this series will discuss the tax treatment of points).
No one obviously likes to pay taxes. But you should follow the advice of a former Supreme Court Justice Oliver Wendell Holmes who once wrote (and I paraphrase):
“When it comes to taxes, which is a creature of Congress, anything
you can legally do to avoid taxes is legal.”
Next: Deducting Mortgage Interest