Due to the whims of the federal government these tips are valid on February 1999, but future changes can be expected.
Please see your tax advisor for specific information.
Deductions: mortgage interest and property taxes
The two classic real estate deductions are mortgage interest and property taxes for a homeowner. Both are mildly misunderstood by taxpayers and real estate professionals alike.
Property taxes are deductible on both a personal residence and other real estate owned without limit if the taxpayer itemizes deductions. This differs from mortgage interest which is limited both by the amount and type of debt and the number of properties owned. Taxpayers that own real property used in a trade or business deduct the property taxes on the appropriate business or rental property schedule. Taxes on personal residences, vacation homes, other real property and vacant land are deducted on Schedule A — Itemized Deductions.
However, the property tax bill’s second cousin, the special assessment is not deductible as a tax. Instead the principal amount of a special assessment is added to the amount of the cost basis of the property and thus lowers the profit upon the eventual sale.
Most people who have owned property since the mid-1980s know that mortgage interest has undergone many changes. Some for the worse, some for the better. The initial change of the Tax Reform Act of 1986 was substantially reversed (not totally) by the 1987 Tax Act. Since that is ancient history we won’t relive that now.
The current deductibility of mortgage interest depends on several things. The first of these is whether the taxpayer already itemizes deduction or claims the standard deduction. If the standard deduction is claimed and the mortgage interest is insufficient (coupled with other items) to exceed the standard deduction, there is no additional deduction.
Assuming the taxpayer does itemize deductions, the amount of properties which constitute home mortgage interest is limited to two. A primary residence and one other property, commonly referred to as a second home. This may be a true second home, or for a child at college, a parent, vacation home, time share and possible recreational housing such as a motor home or boat. In order to qualify as a “home” there must be kitchen, sleeping and lavatory facilities. Rental properties and business properties are not considered in this limit of two and are claimed elsewhere.
The next limitation is on the amount and type of debt on the home(s). The law allows deductions for interest paid on mortgage debt up to $1,000,000 of debt (not interest) that was used to buy, build, or improve the personal residence(s). Additionally, one may borrow up to $100,000 of debt, use the proceeds for other purposes and deduct this interest. For all practical purposes, there is then a debt limit of $1,100,000 on the mortgages encumbering the residence(s). There are some variations, exceptions, exemptions, and limitations on these rules (aren’t there always?) which usually will not apply to most taxpayers.
There are a number of other issues of interest which can be either a problem or an opportunity which I offer here in summary form:
- The number of mortgage is irrelevant (only the number of properties)
- Special assessment interest may be deductible (check the local issues in each case)
- Interest on unsecured debts is not mortgage interest, but it may be investment interest.
- Payments in advance of due date are generally not allowed more than one month in advance and the lender will reflect this in their posting.
- Discount points and loan origination fees (paid by either buyer or seller) to originally buy or build are interest.
- A prepayment penalty is interest if and when paid
- Negative amortization is not deductible in the year accrued unless it is paid that same year. After that it becomes principal and cannot be deducted.
- Personal interest is not deductible on cars, credit cards, etc. This is the overwhelming reason for the popularity of home equity loans or credit lines up to the $100,000 balance limit.
The Federal Taxpayer Relief Act of 1997
The Taxpayer Relief Act of 1997 was approved in both houses of Congress on July 31, 1997 and President Bill Clinton signed the $91 billion tax cut package on August 5, 1997. Among the beauty in this new legislation is a meaningful capital gains tax cut which will allows American taxpayers to unlock equities and end the spiraling cycle of “investing up.” First-time home buyers will see expanded rules for Individual Retirement Accounts (IRA) and 401(k) plans, allowing penalty-free withdrawals to purchase a home. Every two years, married sellers of principal residences (who file joint tax returns) will be allowed a $500,000 exclusion ($250,000 for singles) from capital gains tax. Those who must pay will do so at a tax rate of 20% compared to the previous 28%. Depreciation recapture will be 25% for sales or exchanges, and after 2000, some properties held for five years or more will qualify for an 18% capital gains rate. There’s more – a gradual increase in the estate tax exemption – from $600,000 to $1,000,000 and to $1.3 million for qualifying small businesses and family farms. All this applies to sales or exchanges occurring after May 6, 1997. For those operating a home business, home office deduction rules are clarified and an increase to 100% deductibility of health insurance premiums for the self-employed is promised. Items included in the budget-balancing and tax bills (which Congress and President Clinton approved) include: overall tax relief; overall spending recommendations; and tax changes for education, child credit, tobacco, capital gains, home sales, individual retirement accounts, estate taxes, self-employed health insurance and small business.
Tips on Propositions 60 and 90
WHAT ARE PROPOSITIONS 60 & 90?
They are constitutional initiatives passed by California voters. They provide property tax relief by preventing reassessment when a senior citizen sells his/her existing residence and purchases or constructs a replacement residence worth the same or less than the original.
WHY WERE THEY ENACTED?
They encourage a person, age 55 or older to “move down” to a smaller residence. When a senior citizen acquires a replacement worth less than the original, he/she will continue to pay approximately the same amount of annual property taxes as before.
HOW DO THESE PROPOSITIONS WORK?
When the senior citizen purchases or constructs a new residence, it is not reassessed, if he/she qualifies. The Assessor transfers the factored base value of the original residence to the replacement residence.
Proposition 60 originally required that the replacement and the original be located in the same county. Later, Proposition 90 enabled this to be modified by local ordinance. L.A. County enacted an ordinance to provide that when the replacement is located in L.A. County, the original may be located in any other California county.
The Seller of the original residence, or spouse who resides with the Seller, must be at least 55 years of age at the time of the sale.
IF ORIGINAL PROPERTY WAS DAMAGED/DESTROYED BY DISASTER
1.The damaged property must be substantially damaged or destroyed. “Substantial” means value equal to more than 50% of its full cash value. If “restricted access” is claimed, the condition must be permanent in nature.
2.The property must sustain a loss of value from a disaster in an area so designated by the Governor as a disaster area.
3.The damaged and replacement property must be in the same county.
4.The replacement property must be acquired or newly constructed within three years of the disaster.
5.Upon approval, the new assessment base year trended value will be the lower of the fair market value of the replacement property or the adjusted base year trended value of the property from which the applicant was displaced by reason of a disaster; provided the replacement property and the destroyed or damaged property are comparable. If not comparable, appropriate adjustments will be made for differences in comparability.
Licensed Real Estate Broker with the Calif. Dept. of Real Estate