Your Home Is Your Castle and Your Tax Shelter

Today about 70% of all Americans own their own homes. Besides pride of ownership, there are solid tax breaks accorded to homeowners--during the period in which they own the home and also when they buy or sell the property. These breaks help homeowners lower their tax bills and build wealth. Here are some home ownership breaks to consider:

Breaks for purchasing a home

Becoming a homeowner isn’t always easy. The experience of finding a residence can be challenging and the costs daunting. But the tax law provides some help.

Using IRA funds. Money in a traditional or Roth IRA can be used penalty free up to $10,000 toward the purchase of a residence; ordinarily those under age 59-1/2 are subject to a 10% early distribution penalty for IRA withdrawals. This break, however, applies only to “first-time homebuyers,” individuals who have not owned a residence within the past two years. And this is a once-in-a-lifetime opportunity--anyone who has used the $10,000 penalty-free withdrawal in the past cannot do it again. Remember: This break applies only to penalties; income taxes may still be due on the withdrawals.

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Tapping into 401(k) plans. Looking for a down payment? A plan participant may be able to borrow from the account or take a withdrawal. Tax-free borrowing is allowed up to 50% of the vested benefit in the account or $50,000, whichever is less. Borrowing can be repaid over terms fixed by the plan. So-called “hardship withdrawals” can be used to buy a home after tapping out any loans. These withdrawals are taxable and prevent participants from making plan contributions for up to six months.

Points on a mortgage. Some banks may charge homeowners points to obtain a mortgage. A point is equal to one percent of the amount of the loan (e.g., $1,000 on a $100,000 mortgage). Points can be deductible in full in the year they are paid, at the homeowner’s option deducted over the term of the mortgage. Tip: Those who purchase a home late in the year and do not have sufficient deductions to itemize for that year may prefer to spread points over the term of the loan.

Buying expenses. All other acquisition costs, including legal fees and other expenses, cannot be immediately deducted. However, they become part of the basis in the home, as explained later, and will ultimately reduce the amount of gain resulting on a future sale of the residence.

Annual write-offs during ownership

It can be costly to be a homeowner, but some expenses are tax deductible. These include:

• Home mortgage interest. This includes interest on a mortgage to acquire or build a home (“acquisition indebtedness”) and interest on a home equity loan. Note: Dollar limits apply to these loans: $1 million for acquisition indebtedness and $100,000 for home equity loans. This deduction applies to mortgages on a main home as well as one additional residence. While points to acquire a home may be currently deductible (see above), points on any subsequent mortgage must be deducted ratably over the term of the loan, but if this mortgage is refinanced, any amount that has not yet been written off can be deducted in the year of refinancing.

• Real estate taxes. Property taxes on a residence are fully deductible. There is no dollar limit and the deduction can be taken not only for a main home but for any other residence as well.

Note: Home mortgage interest and real estate tax deductions are claimed as itemized deductions, which may be limited for high-income taxpayers.

Caution: No deduction can be claimed for utilities or maintenance costs, such as lawn care, cleaning or snow removal.

Go green

Cut energy consumption to save on utility bills while also saving on taxes. There are federal tax credits in 2006 and 2007 for making certain energy improvements to a home. These include a 10% credit for adding qualified energy efficiency improvements (for a top credit of $500, no more than $200 of which can be attributable to windows) and a 30% credit for solar energy and fuel cell power plants (for a top credit of $2,000 per energy system). Eligible items for the 10% credit include:

• Insulation systems that reduce heat loss/gain
• Exterior windows (including skylights)
• Exterior doors
• Metal roofs treated with special paint (meeting applicable Energy Star requirements)
• Advanced main air circulating fan (up to $50)
• Qualified natural gas, propane, or oil furnace or hot water heater (up to $150)
• Each item of qualified energy efficient property (up to $300).

Details on the federal tax credit can be found on the new IRS Form 5695, Residential Energy Credits, at www.irs.gov.

There may be state tax breaks and other incentives for going green in a home. These may include deductions or credits on state income tax returns, exemption from state sales tax on energy improvements, property tax exemptions, and financing options. For a database of state incentives for renewables and energy efficiency, go to www.dsireusa.org.

Home office deduction

Homeowners who run a full-time or sideline business from their residence may qualify for a home office deduction. This allows the portion of the mortgage, real estate taxes, insurance, maintenance and other costs to be deducted from business income.

To qualify, a portion of the home must be used regularly and exclusively for business and meet one of the following tests:

• It must be the principle place of business (usually where the money from the business is earned). A home is treated as a principle place of business if it is used for substantial managerial or administrative activities and there is no other fixed location for the business. Examples of these activities: Scheduling appointments, keeping books and records, preparing reports, and ordering supplies.

• It is a place to meet or deal with clients, customers, or patients in the normal course of business. (Incidental or occasional meetings do not qualify for this test).

Note: No home office deduction can be claimed if the residence is rented to one’s corporation. While the corporation can deduct the rent, the homeowner must report rental income without offsetting deductions (although mortgage interest and taxes are still deductible by those who itemize deductions).

Tax-free income when you sell

Homeowners can receive tax-free income up to $250,000 for singles, or $500,000 on a joint return, when they sell a principal residence home. They can use the money to buy a new home, invest for income or for any other purpose. There is no age requirement.

To qualify for this break, the homeowner must have owned and lived in the residence for at least two of the five years preceding the date of sale. In the case of married couples, the $500,000 exclusion applies even though the title is in the name of only one spouse as long as both have lived in the home for at least two years.

Special situations. If a spouse dies before a sale, the surviving spouse is considered to have owned and used the home during any period that the deceased was a homeowner. However, if a sale is not completed until after the year of death, the surviving spouse’s exclusion is limited to $250,000.

If a residence is transferred incident to divorce, the time during which the spouse or former spouse owned the home is added to the taxpayer’s period of ownership. If, pursuant to a divorce or separation, one spouse moves from the marital home but continues to be a joint owner, that spouse is treated as having used the home for any period that the remaining spouse uses the home so as to qualify for an exclusion when the home is eventually sold. For example, if a couple divorced in 2000 but continued to own a home jointly until their youngest child graduated college in 2006, the spouse who moved from the home can meet the two-year use test because he/she is treated as living in the home for the period that the remaining spouse lived there.

Military and foreign service personnel can opt to suspend the five-year period for up to 10 years in certain cases.

Partial exclusion. If the home is sold prior to satisfying the two-year test, a partial exclusion can be claimed if the sale is because of a change in jobs or self-employment location, health reasons, or an unforeseen circumstance affecting the homeowner or a member of the household. For example, if a couple gets divorced or has quintuplets within two years of buying a home, they can prorate the dollar amount of the exclusion for the time they met the test.

Determining gain. Given the price hikes in the real estate market over the past several years, long-time homeowners who sell may have gains that appear to exceed these limits. Be sure to properly figure the amount of gain for tax purposes. This is the difference between “basis” and the price received for the home when it is sold. Basis includes the original cost, as well as any capital improvements to the residence, such as a new roof, the addition of a room, new bathroom fixtures and kitchen appliances. Basis is reduced by any tax credit claimed for energy-related improvements to the home. Tip: Keep track of improvements during the course of ownership in order to minimize gain when you sell the home.

For purposes of determining gain, the sale price is reduced by the broker’s commission and other selling expenses, such as legal fees.

Impact of home office. If a homeowner has claimed a home office deduction, this has no bearing on eligibility for the home sale exclusion. However, any depreciation claimed for the office after May 6, 1997, is taxed in the year of sale at the rate of 25%.