(This is Part 3 of a five-part series. Read Part 1, "IRS debunks common tax myths"; Part 2, "Homeowners get good tax news for 2007"; Part 4, "Home sellers keep profits, avoid taxes"; and Part 5, "Understanding Starker exchange rules.")
"I’m living so far beyond my income that we may almost be said to be living apart." –E.E. Cummings
Are you in the market for a mortgage loan? Whether the loan is to buy a new home or to refinance your existing mortgage, you must shop around. Contact a number of mortgage lenders. Get rate quotes for a fixed 30-year mortgage as well as for adjustable-rate loans.
Find out what the monthly payment will be for each type of loan, but then before you make your final decision, plug in the amount of the mortgage interest that you will be able to deduct.
How do you do this? Let’s look at this example. You find a house that you want to buy and sign a contract for $475,000. You have been saving money for a long time in order to buy your first house, and plan to put down 20 percent ($95,000) and get a loan in the amount of $380,000.
One lender is prepared to lend you this money at 6.5 percent for 30 years, and the monthly payments (exclusive of real estate taxes and insurance) will be $2,402. Another lender has offered you a 5-year adjustable-rate mortgage (ARM) starting at 5.75 percent. This will require a monthly payment of $2,218.
The difference is $184 per month or more than $2,200 per year. Since you are married, file a joint tax return and your taxable income is between $128,500 and $195,800, you know that you are in the 28 percent tax bracket for income tax purposes. Oversimplified, that means that every dollar you pay in mortgage interest can be reduced by 28 percent. So now, after doing the math, the difference between the two types of mortgages is only $132 per month (or $1,584 per year).
It is important to take into consideration the tax deductions available to homeowners when considering what kind of mortgage to get. If you plan to stay in the house for a long period of time, you may be willing to accept the fixed 30-year loan, rather than be subjected to a potentially steep increase five years from now when your ARM will adjust.
It is this very issue that is one of the primary causes of the current "mortgage meltdown" confronting our nation’s homeowners. Many consumers opted for a 100 percent interest-only (or adjustable-rate mortgage) two or three years ago and now have been told that their monthly payment will dramatically increase. These homeowners cannot afford the new payment, and since property values have declined in many parts of the country, they are unable to refinance to get a better mortgage rate.
Let’s look at several interest deductions that can save you money while preparing your 2007 income tax return:
1. Mortgage insurance premiums: If you are able to put down 20 percent or more as a down payment on your home, should you go into default and the home has to be foreclosed, most lenders are comfortable that there will be sufficient equity so that they will not lose any money.
However, if you are unable — or unwilling — to put down a lot of money and want a larger loan, there are two things that lenders can do. They can require that you put down only 5 or 10 percent and give you two loans: one for 80 percent and a second trust for the 10 or 15 percent difference.
Alternatively, they can require that you obtain private mortgage insurance. This is coverage — which the homeowner pays for — to compensate the lender should there be a shortfall between the amount of the money received at a foreclosure sale and the loan balance.
There is also governmental mortgage insurance provided by the Federal Housing Administration (FHA); the Veteran’s Administration (VA), called a funding fee; and the Rural Housing Service, called a guarantee fee.
If you entered into a transaction after Jan. 1, 2007, that included some form of mortgage insurance, you may have the right to deduct these insurance payments as home mortgage interest. However, there are some restrictions. First, the insurance must be in connection with home acquisition debt. This means that the loan is secured either by your principal residence or a vacation home that is not rented out for more than 14 days a year.
The insurance contract must have been issued after Jan. 1, 2007. The deduction is reduced by 10 percent for each $1,000 that the adjusted gross income (AGI) exceeds $100,000 (or $50,000 if you file an individual tax return). If your AGI is more than $109,000 ($54,500 if filing separately) then you cannot take advantage of this deduction.
If you sold your house last year — or refinanced it — thereby cancelling the mortgage insurance, unless the insurance was provided by the VA or the Rural Housing Service, you cannot claim a deduction for the unamortized balance of the premium.
2. 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.
The concept of "acquisition loan" is often difficult to understand. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home or treat it as a home-equity loan.
This can best be understood by an example: You want to take advantage of current mortgage rates, which are still quite low, and refinance your existing $250,000 loan. Your house is assessed for tax purposes at $750,000.
Based on your credit and the equity in your house, your lender is prepared to give you a mortgage loan of $500,000. Because your "acquisition indebtedness" is $250,000, you will be able to deduct interest only up to $350,000 — that is, the acquisition indebtedness plus the maximum $100,000 home equity.
The Internal Revenue Service has ruled that one does not have to take out a separate home-equity loan to qualify for this aspect of the tax deduction. The remaining interest is treated as personal interest, and is not deductible.
3. Seller-paid points: Here’s an area often overlooked by buyers. Points paid to a mortgage lender will reduce interest rates. Each point is 1 percent of the loan, so that on a $300,000 mortgage, a borrower will have to pay $3,000. And typically, for every point that you pay a lender, the interest rate will be reduced by one-eighth of a percent.
When negotiating a real estate sales contract, buyers will often ask the seller to make certain financial concessions so that a deal can be reached. Such concessions include (1) the seller paying some or all of the buyer’s closing costs, (2) the seller giving a cash credit at settlement, or (3) the seller paying some or all of the buyer’s points.
The IRS has ruled that points paid by a seller can be deducted by the purchaser. Let us look at your example. You will pay $450,000 for your new house and obtain a loan of $360,000. The lender can give you a fixed 30-year conventional loan for 6.5 percent, with no points, or 6.25 percent with 2 points, for $7,200. If you can convince your seller to pay this sum — and have your sales contract reflect that the seller is paying this money as points — you should be able to fully deduct the entire payment from your income tax that you file for this year.
There is one drawback to deducting seller-paid points: The amount of the points paid by the seller will be used to reduce the purchaser’s tax basis — the number that will eventually be used to calculate whether a sale results in taxable capital gains. In our example, if you pay $450,000 for the property, and deduct the $7,200 of seller-paid points, your tax basis in the property becomes $442,800 ($450,000 minus $7,200).
Under current tax law, this may not be a problem for home buyers. As will be discussed later in this series of articles, taxpayers who live in their house for at least two years can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence.
Thus, the lower tax basis may not be significant — unless the taxpayer makes a profit that exceeds these amounts.
On Jan. 16, 2008, the IRS announced that it has revised Publication 17, Your Federal Income Tax. According to the IRS, they have "added new features to assist taxpayers to more easily navigate this widely used publication. The online version of Publication 17 now contains electronic links for greater ease of use."
Two other useful IRS documents are Publication 936, entitled "Home Mortgage Interest Deductions," and Publication 910, "IRS Guide to Free Tax Services." It is to be noted that the IRS has cautioned consumers that if a Web site purporting to be from the IRS does not contain the ".gov" suffix, it is not a legitimate IRS Web site.
Next week: tax implications when selling your house.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@sandbox.inman.com.
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