Tax Issues Related to the Personal Residence

Personal Residence Issues - Delaware CPA FirmPosted by Michael Kelly, CPA

When we think about our personal residence, we probably do not give much thought to the tax impact associated with it. If we do think about the tax aspect, our focus probably is on the savings related to the mortgage interest and real estate tax deductions. Even though these two deductions are very powerful, they are not the only tax benefits related to home ownership. Some additional tax benefits, limitations, and possible problems are listed below.

Mortgage Interest and Real Estate Taxes on Multiple Homes

Interest paid on home acquisition debt of $1,000,000 is deductible. If the debt exceeds $1,000,000, the interest deduction may be limited. However, there is a special rule described below that will generally increase the limit to $1,100,000.

Acquisition debt includes acquiring, constructing or improving a taxpayer’s first or second home. If a taxpayer owns more than two homes, he may choose which one he wishes to treat as his second home each year.

Home equity interest is deductible as long as the related debt does not exceed $100,000; otherwise it will be limited. Home equity indebtedness is any debt that is secured by the main home and doesn’t qualify as home acquisition debt. For regular tax purposes, it does not matter how the proceeds are used. However, if they are not used to buy, build, or substantially improve the main or second home, the interest deduction is disallowed for alternative minimum tax purposes. There is also a special rule available that allows a taxpayer to treat his home acquisition debt as home equity debt, which allows the taxpayer to deduct interest on total home acquisition debt of $1,100,000.

There are not any limitations associated with real estate taxes.

Private Mortgage Insurance Premiums

Private mortgage insurance, commonly known as PMI, may have to be paid by borrowers if their debt to equity ratio is too high. For tax purposes, PMI is treated as mortgage interest and is deductible. However, the deduction is not allowed for high income earners and is completely phased out if income levels exceed $54,500 ($109,000 married filed jointly). This deduction expired at 12-31-13 but may be retroactively renewed.

Points

Most lenders charge points to borrowers when new funds are lent or old debt is refinanced. Points paid on the purchase of a primary residence are generally deductible in the year of payment. However, points paid on a second residence must be amortized over the life the loan. Points paid to refinance a loan on the principal residence may be deductible in the year of payment if the proceeds are used to improve the home; otherwise they generally must be amortized over the life of the loan. If a loan is paid off early, the remaining unamortized points generally can be deducted.

Gain Exclusion

Congress does not allow a taxpayer to deduct a loss on the sale of his personal residence, but is gracious enough to allow taxpayers to exclude gain up to $250,000 ($500,000 if married and filing jointly) from income by using the Section 121 gain exclusion. The taxpayer must own and live in the home for at least two of the last five years prior to the sale to qualify for this exclusion. Under limited circumstances, a taxpayer may be able to use a portion of the exclusion if he does not meet the two-year requirement.

Cancellation of Qualified Principal Residence Indebtedness

As painful as it sounds, unintended tax consequences may occur if a bank forecloses on a taxpayer’s home mortgage and takes possession of the home. If the relieved debt exceeds the fair market value of the repossessed property, then the difference is considered taxable income. It seems unfair for taxpayers who lose their home and then have to pay taxes on top of it. As a result, Congress established the Mortgage Forgiveness Debt Relief Act which prevents this type of income from being considered taxable (as long as the debt meets certain criteria.) The Mortgage Forgiveness Debt Relief Act expired as of 12-31-13 but may be retroactively extended.

Home Office Deduction

A taxpayer who owns a business and works from home may be able to deduct expenses associated with his home office if it is used exclusively for work. A taxpayer can choose between two methods to determine the deduction. The first method, known as the simplified method, allows a deduction equal to $5 multiplied by the home office’s square footage. The second method is based on a reasonable method which takes into account the total expenses of the home and allocates a portion of them to the home office. Depreciation associated with the home office may be deducted if the second method is used; but upon the subsequent sale of the property, a portion of the gain may be taxable to the extent of depreciation previously deducted. The Section 121 gain exclusion does not shield the taxpayer from this rule. There are benefits and drawbacks with each method and careful consideration must be used to determine which is best.

Dual Use

It is not uncommon to eventually move into a home that was previously used for rental purposes, but the owner needs to consider a few items before subsequently selling the dual use home. As long as the taxpayer lives in the home under the two-year rule as described in the above Gain Exclusion section, he will still be eligible for a portion of the exclusion upon the sale. However, similar to the home office issue, the depreciation associated with the rental property will not be eligible for the exclusion.

Any remaining gain must be allocated between the following: 1) number of days which the taxpayer used the property as a principal residence (qualified use) and 2) the number of days that he used it as a rental property (non-qualified use). The portion of any gain that is allocable to qualified use will be eligible for the exclusion while the non-qualified portion will be subject to income taxes.

Taxes should never drive a person’s decision in anything in life, including whether or not to own a home, but the tax impact should not be forgotten.

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