With the April 17 tax deadline fast approaching, taxpayers naturally are concerned with ways to minimize their obligation to Uncle Sam.
Current tax law still provides substantial shelter for gains on the sale of a home, said Robert G. Walters, senior vice president of Baird & Warner, a Chicago real estate firm with 31 local offices.
On the sale of a principal residence, sellers can roll over a gain and pay no tax on it if they invest the total revenue from the sale in another home within 24 months.
In addition, people 55 and over can use a once-in-a-lifetime exclusion of up to $125,000 profit from the sale of a principal residence.
But if you sell a second home, or sell your principal residence but don`t buy a new one soon enough or for a high enough price or are unable to qualify for the $125,000 exclusion, you can lose as much as 33 percent of your profits to taxes, depending on your tax bracket.
What`s more, as home prices rise, the value of the $125,000 exclusion is being eroded and could present a problem for retirees, according to Richard Jurgovan, senior manager of executive financial planning at the accounting firm of Deloitte, Haskins & Sells.
Jurgovan said that sellers in years to come who move from a large home to a less expensive retirement residence may find that an $125,000 exclusion, not indexed to inflation, will not shelter all their profits.
”I haven`t seen too many situations like that yet, but they certainly could begin to develop down the road,” he said.
What is clear already is that tax reform has had considerable impact on how people are using their second homes, once used primarily as tax shelters. Under the old tax laws, owners who occupied their second homes no more than 14 days a year could treat them as rentals and deduct not only mortgage interest and real estate taxes but also depreciation and other expenses. Today such deductions are tightly limited.
”More and more vacation home owners are now treating these homes as residences rather than as investment real estate,” said Stephen Robin, a partner in the tax division of Arthur Anderson & Co., and a specialist in personal financial planning.
”This lets them avoid the limits on deductibility that apply under the passive loss rules now governing such rental properties. As a result, they can deduct all the mortgage interest and real estate taxes and can use the property more often for their own enjoyment.”
Another good reason to adopt this approach is that if a second home is rented out no more than 14 days a year, the rent received need not be reported as income under present tax law.
One important way to reduce taxes on the profits of a real estate sale is to keep good records. Many of the costs of buying and selling a house, as well as money spent on improvements made during ownership, can be added to the price of the property and thus reduce the taxable profits, Walters, of Baird & Warner, said.
These deductible items include fees for attorneys, title searches, appraisals and surveys; the cost of remodeling or of building an addition; and the cost of putting in any sort of permanent improvement, such as a fence, TV antenna, storm windows, landscaping or even a basketball hoop along the driveway, according to Walters.
You also can subtract sales related costs, such as broker`s commission, tax stamps and certain fix-up costs incurred within 90 days of the date your home was put up for sale.
”It`s amazing what you can spend on house improvements in 10 years of ownership,” said Frank Wolff, president of the Illinois Mortgage Bankers Association.
Homeowners who keep all receipts in one special file often save themselves remarkable amounts on taxes, Wolff said.
Another key tax strategy is to replace nondeductible debt with tax-deductible debt.
These days, tax-deductible debt usually means a home mortgage or home equity loan, said Robin, of Arthur Anderson & Co.
Under the Tax Act of 1986, debt secured by a taxpayer`s primary residence is classified as either acquisition debt or home equity debt.
Acquisition debt is mortgage debt taken on to pay for the purchase, construction or substantial improvement of a residence. Interest on acquisition debt of up to $1 million is fully deductible.
Home equity debt is essentially any other debt secured by a residence. Interest on home equity debt is is treated less generously, with full deduction permitted only for interest on the first $100,000 of such debt.
The passage of the tax reform in 1986 caused many experts to predict that the loss of other deductions, especially the phaseout of interest deductions on personal loans, including auto loans and credit card purchases, would spur millions of families to start tapping their home equity for a wide range of purposes, from college tuition to vacation travel.
An informal survey of people who deal with home financing and tax planning in the Chicago area suggests that those early predictions were pointed in the right direction but probably exaggerated the extent to which homeowners would utilize this source of tax-deductible credit.
One reason for this restraint, according to Robin, is that ”the lower tax rates now in effect have reduced the tax sheltering power of deductions, especially for upper bracket taxpayers.”
Under the old tax rates, Uncle Sam in effect would pick up half the cost of interest payments for those in the 50 percent bracket. Now he picks up no more than 33 percent, even if the interest is fully deductible.
This change, along with the recent increase in interest rates, has driven up the after-tax cost of borrowing, making it less attractive, Robin said.
Despite the reduced tax shelter that deductible interest offers, lenders expected a boom in home equity loans, and according to Jim Matthews, senior vice president of Talman Home Federal Savings, they have not been
disappointed.
”Home equity lending has become the `shining star` of consumer lending,” Matthews said.
”Five or six years ago, home equity lending was a minuscule part of our business, no more than 5 percent. Today, 35 to 40 percent of the consumer loans we make are either home equity loans or home equity lines of credit.”
By and large, Matthews finds that the homeowners he talks with are not tapping their home equity to pay for a fancy new car or deluxe vacation. Rather, they borrow against their home equity for the reasons they always have: home improvements, retirement or the need to raise funds for business.
”People aren`t silly,” Matthews said. ”They realize they have to pay these loans back; so they take a pretty conservative approach.”
Even the increase in home equity lending has been offset largely by a decline in unsecured personal loans and auto loans, according to Bruce Pudge, vice president for consumer lending at Land of Lincoln Savings.
”People aren`t borrowing more money now; they`re just using a different type of loan,” Pudge said.
The changes in behavior that have been observed, especially in the area of home equity loans, are most pronounced among home buyers and owners in the higher income brackets, who have both the means and the incentives to reduce taxes.
Matthews noted that wealthier customers have been the most frequent users of Talman`s home equity credit lines, in part because they have the most equity in their homes.
Jurgovan, of Deloitte, Haskins & Sells, reports that he is ”seeing families with incomes of $100,000 or more move toward home equity loans very aggressively.”
While home equity lending has increased markedly, the story has been different in the area of refinancing, in which homeowners take out an entirely new mortgage and pay off their old mortgage.
”We haven`t seen the volume of home refinancing that had been predicted,” said Wolff, of the Illinois Mortgage Bankers Association.
Because of the changes in the tax law, home buyers with higher incomes may be putting less down on the new homes and taking on bigger mortgages.
”At the upper price levels (of the home market) more people are taking out maximum mortgages, sometimes over $500,000,” said Joyce Burke, president of First United Realtors, a Naperville-based firm with 32 local offices.
”At the lower price levels, people are more concerned with the size of their monthly payment than with maximizing tax benefits.”
The possibility that at least some home buyers are moving toward larger mortgages is confirmed by the experience of William Maybrook, vice president of sales and marketing for Lexington Homes, one of the largest home builders in the Chicago market.
”The average size of the mortgages on the homes we sell has risen 25 percent in the last three years,” Maybrook said. ”At the same time, the average price of the residences covered by those mortgages increased only 18 percent.”
The best way for homeowners to tap their equity will vary with individual circumstances, but one lender strongly suggests that the riskiest approach is the home equity line of credit, which allows borrowers to write checks up to a certain ceiling and make minimal monthly payments.
”When the line of credit must be repayed, typically in three to seven years, many consumers will have to make a large single payment or face foreclosure,” Pudge said.
”The first big batch of these loans will come due in a year or two, and we`re waiting to see how consumers handle it.
”The fear is that people won`t be ready to repay and that this will trigger a large number of foreclosures. Already the federal government is working on new legislation to increase the disclosure warnings given to people considering this type of loan.”
According to Pudge, Land of Lincoln counsels its customers against taking out home equity lines of credit and encourages them to use straight home equity loans that are amortized by fixed monthly payments.
”Consumers have gotten what they`ve asked for,” Pudge said. ”The question is whether they really will be better off for it. Few people have the discipline to put aside money voluntarily for a debt that isn`t due for several years.”
