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01/08/08: A Primer On Real Estate Taxation

Housing Counsel

A PRIMER ON REAL ESTATE TAXATION

By: Benny L. Kass

[Second of a Series]

"The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin." Mark Twain.

It is time to start planning for the experience of preparing and filing your 2007 income tax return. The IRS would have us believe that the average taxpayer spends only 3.7 hours in completing form 1040, although it admits that by including tax planning, form submission and record keeping, the total average time increases to 33.5 hours.

And if we add frustration and procrastination into this equation, we should already have started the process.

And Congress has not helped the situation. By enacting in late December a so-called "patch" for the Alternative Minimum Tax (AMT), the IRS has advised that they may not have all of the forms ready for publication until at least February 11. Some 13 million taxpayers will have to wait until then before they can file.

You do not actually have to file form 1040 on April 15th. There is an automatic six month extension until October 15th, in which to file. But to take advantage of this extension, taxpayers must file form 4868 - and pay the full amount of the tax you owe for 2007 - on or before April 15th. If you are a United State citizen or resident and are out of the country, you are given a two month reprieve, and must file by June 16, 2008 without having to request an extension. "Out of the country" is a defined term: you have to live and work outside of the United States and Puerto Rico. You just cannot conveniently be in Canada on the 15th to avoid filing.

But Congress gave homeowners two holiday presents at the end of last year.

If you bought a home in the District of Columbia in 2007, and if you (or your spouse) did not own a principal residence in DC during the one year period ending on the date of purchase, you may be eligible for a credit of up to $5000. This provision has been around for a number of years, but must be renewed occasionally, which is what Congress did.

Additionally, Congress extended the right for many taxpayers to deduct as "mortgage interest" any private mortgage insurance premiums paid during the previous year.

These and other issues will be discussed later in this series of tax columns.

In order to understand the complex concepts included in the tax code, let's start with some basic definitions:

  • "basis" -- the initial cost of the property,
  • "adjusted basis" - add to basis the cost of any capital improvements you have made over the years. Also such items as settlement fees, closing costs, recording fees, recordation and transfer taxes paid, legal fees, title insurance and real estate commissions will increase your bais.
  • "gross profit" -- the difference between what you originally paid for your house and the sales price
  • "net profit" - this is the difference between gross profit and adjusted basis. The bottom line net profit is your "capital gain."

Despite the increasing foreclosure rate, the majority of American consumers still dream of owning their own home. According to the Census Bureau, in the third quarter of 2007, over 68 percent of the nation's population owned a home. (US Census Bureau News, October 26, 2007). And Members of Congress understand that their constituents want to keep the significant tax breaks currently in the law. As will be seen in subsequent columns, homeowners are 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.

We used to have two different tax benefits. The first was called the "rollover". When you bought another principal residence within two years (before or after) you sold your main home, you were able to defer any capital gain that you may have made on that sale.

Second, when you reached the age of 55, you were able to take a one-time exclusion of up to $125,000 of the profit made on the sale of your principal residence.

But in 1997, Congress repealed both the "rollover" and the "once in a lifetime" exclusion. I often have to repeat this, because too many older American homeowners still believe these concepts are available to them when they sell their home. We now have a much more favorable tax treatment in the $250-500,000 exclusion.

Renters often complain that they are treated unfairly. Homeowners can save tax dollars by taking certain deductions which are not available to tenants. And while this is true, it is nevertheless a fact of life - and law.

Here are 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. Mortgage lenders who receive more than $600 in interest per year are required to send an annual statement (IRS Form 1098) to their borrowers by the end of January of each year, reflecting interest paid for the previous year.
  • Private Mortgage insurance premiums: as mentioned above, this tax benefit remains on the books for tax year 2007. In fact, the extension approved by Congress in December made those payments deductible for loans originated through 2010. There are, however, income limits on eligibility.
  • 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 2007 return.

On the other hand, if you bought a house last year, you may have reimbursed your seller for a portion of the prepaid taxes through the end of 2007. 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.

And don't forget to take this deduction even if your mortgage lender was escrowing money for your real estate tax. The deduction still belongs to you.

  • Points. In the past few years, fewer consumers were paying points to "buy down" the interest rate on their mortgages. But if you did pay 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 $325,000, each point will cost you $3,250.00. (A column later in this series will discuss the tax treatment of points).

If you need assistance with your tax returns, you have several options. First choice: retain a professional tax accountant or other qualified tax preparer. 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 service.

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 (TAS). According to the IRS instructions for filing Form 1040, 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 "2007 - 1040 Instructions, at p. 3).

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.

Next: Deducting Mortgage Interest

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