01/03/10: It's Never too Early for Tax Planning
By Benny L. Kass
"Tax reform is taking the taxes off things that have been taxed in the past and putting taxes on things that haven't been taxed before"
Health care reform. No cost of living increase for social security. Estate tax corrections.
All unfinished business as Congress left for their holiday vacation.
But a mere 96 days remain before your federal income tax return must be sent to the Internal Revenue Service.
True, you can file IRS form 4868 and receive a six months automatic extension, but you still have to pay the full amount of the tax you owe for last year.
We are all procrastinators, but now is the time to start preparing so as to make sure that you take all of the deductions and credits authorized by law.
If you bought (or plan to buy by June 30) a new home, you may be able to take the first time home buyer credit on your 2009 return. If you installed energy home improvements - such as windows and doors - in your principal residence, you may also be able to take a credit up of up to $1500. And if you bought a new car between February 17, 2009 and the end of last year, you might be able to deduct the state and local taxes on the first $49,500 of the purchase price.
A good first step in determining you tax obligation is to go to the IRS website. There you will find a host of publications which you can download if you have internet access, or get directly from the IRS. Perhaps the most comprehensive publication is Number 17, a 280 page booklet entitled "Your Federal Income Tax for Use in Preparing 2009 returns".
This series of articles is aimed at assisting homeowners in understanding the basic concepts of our tax laws. You want to maximize your deductions, since if you are in the 33 percent federal tax bracket, for example, every dollar you can legally deduct will save you 33 cents. Of course, this would not benefit you if you opted not to deduct and take the standard deduction, but that's a decision only you can make after reviewing your situation with you tax and financial advisors Let's start with some basic definitions.
- credits versus deductions: according to Julian Block, tax attorney and author of "The Home Seller's Guide to Tax Savings", most people do not understand the difference between these two legal concepts. "Credits," he writes, "lower a person's taxes dollar for dollar, making them more valuable than deductions, which merely reduce the amount of income on which taxes are figured"
Block provides this example: "a deduction of $1000 saves $350 in taxes for someone in the highest bracket of 35 percent, but only $100 for someone in the lowest bracket of 10 percent A credit of $1000 reduces taxes by that amount, whatever someone's bracket is".
- basis -- this is 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."
For those of us who own homes, here is a list of tax deductions. As will be discussed in other columns in this tax series, in many cases there are income limitations imposed by the tax code, so you have to carefully review your own financial situation to make sure you are eligible for these deductions:
- 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 - also called "acquisition indebtedness" -- is very important, and has confused - and even trapped - a large number of homeowners. In order 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 of the excess to improve your home. However, any other excess may qualify as a home equity loan.
Many Washingtonians have purchased homes in excess of $1 million. Recently, the IRS was asked for its opinion on the following facts: taxpayer buys a principal residence for $1.5 million, puts $200,000 down and borrows the difference of $1.3 million. According to the IRS, the first million is acquisition indebtedness, and up to $100,000 of any debt exceeding a million will qualify as home equity indebtedness. Accordingly, the taxpayer would be allowed to deduct the interest paid up to $1.1 million of the mortgage loan.
Here's another example: Several years ago, you purchased your house for $180,000 and obtained a mortgage (or deed of trust) in the amount of $130,000. Last year, your mortgage indebtedness had been reduced to $120,000, but your house was worth $300,000.
Because you wanted to pull out some cash from the equity in your home, you refinanced and were able to get 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, but since it is under $100,000, it qualifies as a home equity loan.
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 would have borrowed $225,000, you are only able to deduct interest on $220,000 of your loan -- the $120,000 acquisition indebtedness, plus the $100,000 home equity.
The remaining interest is treated as personal interest, and is not deductible.
-- 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 2010, you cannot take a deduction for these taxes when you file your 2009 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 2009. Review your settlement sheet (called a HUD-1) 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, (Form 1098) that amount may not be included, because it was just an adjustment between buyer and seller and not a payment collected by the lender.. 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 $220,000, each point will cost you $2,200.00. The new Good Faith Estimate and the revised HUD-1 that as of January 1, lenders are now required to use will assist you in determining the cost of these items.
- Mortgage Insurance Premiums: if you paid such premiums last you may be able to deduct that cost. Such premiums would be paid under a private mortgage company, or for loans insured by such agencies as the Veterans Administration (called a "funding fee") or the Federal Housing Administration. Discuss this with your tax advisors because there are income limitations which may preclude you from claiming these payments as deductions.
The IRS tells us that the average time to complete the basic form 1099 (exclusive of attachments) is seven minutes. Good luck!
(Next: What is Your Principal Residence?)