Tax laws have always been complex, but they`re even more so now that Congress has tried to simplify them. I can`t begin to cover all the intricacies of the tax code, and what you read here shouldn`t be taken as a substitute for the professional tax-planning advice you need. But it will give you a general idea of some of the deductions available to you as a property owner.
Mortgage interest
Homeowners are allowed to deduct the interest paid on money borrowed to purchase or improve a first or second home, up to a maximum mortgage total of $1 million. If you borrow $150,000 to buy your house, then borrow $75,000 more for a summer home, the interest you pay on both mortgages will be fully deductible. If the combined total of the mortgages on your first and second homes exceeds $1 million, however, the interest on the loan amount above that is not deductible. And if you own more than two homes, you can claim a residential-mortgage-interest deduction only on two of them, though the interest on the other properties may be included in the deductions allowed for the ownership of rental property, if indeed you rent it out.
The mortgage-interest deduction is important to you not only because it`s sizable, but also because it`s just about the only significant deduction left to consumers now that the deductions for interest on consumer loans are being phased out.
Points
Points represent charges that borrowers are required to pay lenders in advance during the process of obtaining a mortgage. Under certain conditions, the IRS allows you to treat these charges as prepaid mortgage interest, which is deductible.
The conditions are: (1) you may deduct points paid only on the purchase of a primary residence; (2) the payment of points must be an established practice in the area; and (3) the number of points you pay must not exceed the standard for the community. To illustrate: If most lenders in your area charge two points and you paid five, you`ll be able to deduct only two of those five points in the year in which you obtained the loan. The remaining three points can be deducted, but the deduction must be spread over the lifetime of the loan. That is, if you have a 30-year mortgage, you can deduct 1/30 of the total deduction each year for 30 years, or until the loan is repaid. There`s still a benefit, but it`s not quite so interesting, especially considering that most people sell their homes within six or seven years.
Another big detail about points is that they can`t be deducted in the year in which they are paid if what you`re doing is refinancing an existing mortgage. As with points paid in excess of the market standard, points paid in connection with the refinancing of an existing mortgage must be deducted proportionately, over the life of the loan. There have been some efforts in Congress to amend that requirement, but so far they haven`t been successful.
Property taxes
Any state or local real-estate taxes you pay are also deductible from your federal tax bill.
Condos and cooperatives
If you live in a condo, the interest you pay on your mortgage is deductible, and so are your property-tax payments, just as if you owned a detached single-family home. No deduction is allowed, however, for the monthly maintenance fee on your condominium.
Cooperatives are a little different. The interest on the cooperative-share loan you obtain to finance the purchase of your unit is deductible, just as the interest on a home-mortgage loan would be, but only if the cooperative meets one very important condition: At least 80 percent of the income earned by the cooperative corporation must come from the fees paid by residents of the co-op development. This means that if there`s commercial space in the building, or if the co-op has funds invested, those sources can`t produce more than 20 percent of the corporation`s total income without jeopardizing the interest deductions available to the individual cooperative owners.
In addition to being able to deduct the interest on cooperative share loans, co-op owners can also deduct the portion of their monthly fee that represents their share of the property taxes and the blanket mortgage on the building. The balance of the cooperative monthly fee, however, which covers maintenance and other common expenses, can`t be deducted.
Second mortgages, equity lines
Interest may be deducted in full on a second mortgage (or on a home equity line of credit) obtained on a first or second home, up to a maximum loan of $100,000.
For second mortgages or home equity lines greater than $100,000, though, the interest is deductible only if the funds are used for ”substantial” home improvements. What qualifies as a substantial improvement is, naturally, not defined in the law. You must assume the IRS will define the term as restrictively as it can.
If you`ve always wondered what the difference is between a home equity line of credit and a second mortgage, here it is:
A second mortgage is a loan for a specified amount, written for a specified term and targeted for a specific purpose. When the loan is approved, the borrower receives it in a lump sum.
An equity line of credit, on the other hand, is a preapproved credit line. Like the second mortgage, it`s secured by the home, but it operates more like a revolving charge account.
If you obtain a second mortgage for $50,000, you begin paying interest on the full amount immediately, and you must repay the entire amount by the end of the loan term. With an equity line, you might receive approval for a $50,000 account but leave it untouched for a year. And in that case you would incur no interest charges.
To give an example: If you borrow $10,000 from the $50,000 equity account and repay $2,000 of the principal plus the interest owed the next month, you`ll have $42,000 available on your credit line-that is, the $40,000 remaining after your initial loan, plus the $2,000 you repaid.
This illustrates the other important feature of the equity line: the principal that you repay becomes available to be borrowed again, with no further approvals required by the lender. On a second mortgage, your repayments reduce the loan principal but don`t enable you to borrow additional funds. To borrow the money repaid on a second mortgage, you have to apply for another loan.
Improvements and repairs
You may be surprised and disappointed to discover that you can`t deduct the cost of improving or repairing your new residence.
The fact is, however, that the system isn`t set up that way. The first point is that repairs and improvements are different in the eyes of the IRS. The second point is that for a primary residence, the distinction doesn`t matter, because neither repairs nor improvements are deductible.
A repair is anything you do to keep your property in good condition, such as repainting it inside or out, fixing its leaks, replacing its broken windows or mending its fences. All such measures qualify as repairs and may endear you to your neighbors, but none of them improves your tax situation. Repair costs are deductible on rental property under certain conditions, but not on a primary residence.
An improvement, unlike a repair, adds to the value of your property or prolongs its life. Adding a room, finishing a basement, putting up a fence (as opposed to mending an existing one), replacing the roof, installing a driveway-these are all definite, unambiguous home improvements. You can`t deduct them, either.
You can, however, add the cost of any home improvements to your home`s
”basis”-that is, its value, which will be the financial starting point for calculating the ”gain” you must tally for tax purposes when you ultimately sell it. Keeping accurate records of the improvements you make over the years is absolutely essential to ensure the most favorable tax treatment possible when you do sell.
So don`t throw those old bills away. File them if you can, stuff them in a drawer or stick them in a book. But hold on to them. Later, you`ll be glad you did.
