No matter whose lips you read, the mere mention of income taxes is enough to send a shiver down your spine, straight to your wallet. Even that so-called tax reform a few years back did little to ease the yearly April malaise, and with new ”revenue enhancing” measures looming on the Capitol Hill horizon, Uncle Sam soon may be snatching more of your pennies than ever before.
So, you`ve got some choices.
You could pack up the kids and move to a bunker in North Dakota, join the ranks of the anti-tax Posse Comitatus and wait for Internal Revenue Service agents to smoke you out-but you`d better like freeze-dried food and living among the heavily armed lunatic fringe.
Or you could just throw your hands up, write that big check and watch as up to a third of your income floats away each year. It`s an easy, but hardly economical, solution.
Which brings us to option No. 3.
You could buy a house.
It may seem an extreme way to cut your tax bill and the details can get a bit murky, but the big picture remains the same: Home ownership is the best
(legal) way to slice and dice the bottom line of your 1040 form.
Still the biggie
”Owning a home is the big banana when it comes tax time,” said Gerald Howard, real estate tax counsel for the National Association of Home Builders in Washington, D.C. ”For most people these are the deductions that matter the most. Whether you`re buying or selling your home, you score points. That usually means saving a couple of thousand dollars-at least.”
In fact, the deductions related to home ownership aren`t just the big banana, they`re some of the last large deductions still available to the average taxpayer. While most tax shelters were decimated in the tax reform upheaval of 1986, including those important deductions for consumer loans, home ownership was a lone sacred cow and escaped Congress` legislative tax ax. ”The single-family home is still the virgin tax deduction,” said Dorcas Helfant, executive vice president of the National Association of Realtors.
”The people in Washington knew that and responded by putting a protective blanket over (home-related deductions) when they started cutting exemptions.” What now remains is a set of deductions and exemptions that buttresses the health of the home-building industry as well as the hopes of most would-be homeowners. Taking advantage of the law, home buyers can cut their tax bill, redirect saved income and build tax-free equity for years to come.
For real-estate professionals, these tax advantages are old news. However, they find that many times, prospective home buyers give the savings only scant attention.
”I usually tell people that a house is not a tax shelter in the traditional sense,” said Chicago real estate attorney Mary Milano. ”It is also the largest investment that individuals make. With that kind of investment you have to consider everything before you buy. That includes the tax status of the property.”
Expensive afterthought
For most people, however, the notion of tax breaks is usually an afterthought that follows such initial concerns as price, location and size. Only after the contract has been signed and escrow closed does the tax man usually get his due. Unfortunately, that can mean losing the edge when it comes to getting the most out of your property.
”The best time to start (thinking about taxes) is when you`re trying to make your decision about a specific property,” Howard said. ”A smart consumer will figure the tax ramifications as they begin to narrow the list down.
”There are some breaks that may or may not avail themselves to some homeowners, including energy credits that can be taken advantage of or provisions such as those regarding historical districts that don`t apply to everybody. See what tax savings are available, then make your decision.”
These more obscure tax breaks are part of an intricate web of regulations that homeowners are often unfamiliar with. However, buyers should be ready to ask a tax attorney or experienced real estate agent questions regarding the tax status of a property they consider purchasing.
Short and sweet
The list of standard deductions, though amounting to substantial savings, is really quite short. By working the math while you are still shopping, you`ll be able to forecast your savings and compare the benefits of several properties.
The two most significant deductions relate to the interest on your mortgage and the real estate taxes assessed on the property. As is the case with most of the allowable deductions for real estate, you must itemize them on your federal tax return (form 1040, schedule A or other similar schedules) to qualify.
The IRS allows for a 100 percent deduction for the interest paid on your mortgage, up to 13 monthly payments a year. So, if you make your January 1991 payment next December, you can add that extra month`s interest payment to your deduction for 1990.
Also, depending on how the transaction is structured, the points (each equal to 1 percent of the loan amount) you may have to pay the bank for arranging the loan are also deductible. In order to deduct this fee in the year the home is purchased, the points must be paid by a separate check. Otherwise, you`ll be able to deduct it only over the course of the loan.
For example, if the bank charges 3 1/2 points on a 30-year, $100,000 mortgage-or $3,500-the borrower must write a separate check for that amount to qualify for the full deduction that year. If the charge is included in the loan, you would be able to deduct the $3,500 only over the life of the loan. That would mean a yearly $117 deduction for 30 years instead of the one-time $3,500 write-off.
File it away
Needless to say, keeping track of that check is of paramount importance, as is maintaining meticulous records of the entire purchase transaction. Homeowners can easily lose between 30 to 40 percent of their deductions because of sloppiness and a disregard for keeping all transaction records in order, according to the IRS.
Besides, when the auditor calls, it`s best to have your ducks in line, lest you be a dead duck yourself.
The second most important deduction relates to the real estate taxes assessed on your property. They, too, are 100 percent deductible. As is the case with figuring your mortgage interest costs, this can (and should be)
figured before the sale to measure the size of your tax savings.
A simple check with the county assessor`s office should give you the tax history of the property, including plans for a reassessment of the property`s value.
Together, the deductions for mortgage interest and real estate taxes form the base of most homeowner breaks. However, there are other conditional deductions that may apply-the most significant of which are those relating to job relocation.
”This is where a lot of people miss out on what they can get back,”
Howard said. ”As long as people qualify, according to the guidelines, they can make up whatever their employer is unable to cover. That can mean everything from baby-sitters who watch your kids during the move to McDonald`s along the way.”
To qualify for the deduction of moving expenses, you must have been forced to move because of a change in job location-regardless of whether you change employers. The new job site must be 35 miles farther away from your old home than your previous place of employment.
If you qualify, you may deduct all of your household moving expenses plus up to $3,000 in indirect costs, which include the sales commission paid on your old home, costs of staying in a hotel and costs incurred during house-hunting trips. However, you may not deduct any portion of the expenses that have been paid by your employer.
To claim these deductions, you must file a separate form, No. 3903, along with your 1040. It`s best to first get the IRS`s free document (publication 521) that explains all the rules. It`s available free from the IRS, as are many other explanatory publications, by calling its publications hotline at 1-800-424-3676.
Again, it`s easy to lose track of all those niggling expenses incurred while moving. Remember to keep accurate records.
Extra protection
For moveup buyers, or those relocating, the gains of buying can be coupled with the tax advantages offered to those selling a home. In this case, we`re talking specifically about provisions for avoiding the pit-bull bite of capital gains tax.
Unless President Bush gets his way soon and the gains tax is abolished altogether, home sellers will have to be concerned with dodging this portion of the tax code. Otherwise, it could mean losing tens of thousands of dollars. ”Most of the clients I deal with are relatively sophisticated, but this is an area in which even the best versed homeowner can get lost,” said Milano. ”Most people don`t understand that moving up into a more expensive house isn`t just a good thing from the standpoint of prestige. It`s also one of the best ways to protect your equity from becoming a tax liability.”
The capital gain from the sale of your home is determined by the net sales price of your home-the gross sales price (what is listed on the sale contract) minus the adjusted cost of the home when you bought it.
This adjusted cost is a combination of factors, based essentially on what you paid for your home plus the expenses you paid while living there and what it cost to sell it.
To figure your adjusted cost, add the purchase price to all costs incurred during ownership that have not already been claimed as deductions. This may include transaction costs such as the appraisal, legal fees, commissions, escrow title charge and transfer taxes.
Also, if improvements were made to increase the saleability of the home, and were started no more than 90 days before signing the sales contract, they, too, may be subtracted from the taxable gain. This does not, however, cover those expenses that would have been necessary anyway-such as fixing the roof, plastering walls and the like.
What it can include are improvements ranging from the addition of a new room to the upgrading of appliances in the home.
If you buy another home within 24 months of the sale of your previous home, and it is of equal or greater cost, then the tax on the capital gains from your previous home will be deferred. This ”rollover residence replacement rule” applies to primary residences and means you won`t pay taxes on the profit within the year of the sale.
Otherwise, expect to give a large portion of your net profit right back to the government.
Off the hook
The only exception to this rule is a one-time exemption offered to people 55 and older, who may exclude up to $125,000 in profits ($62,500 if married and filing separately) from the sale of their home.
This exemption includes gains deferred from previous sales, but it does have certain conditions attached. First, the sale home must be the principal residence of the seller for at least three of the five years before the sale. Also, this is a one-time chance. If the entire $125,000 is not used, it will be lost forever.
”This is where many older people lose out,” said Howard of the National Homebuilders Association. ”They don`t realize how much they can take, or if they don`t take the entire deduction that they may have thrown thousands of dollars in savings away.”
Ignorance is the culprit for most tax losses, Howard said. The best rule is to know what is available, ask as many questions as possible and keep the records to prove you have stuck to the letter of the law.
In doing so, when April rears its ugly head you`ll give the government its due, while removing the specter of taxes eating away your income.
Either way, we think that beats living in a cave in North Dakota.
