Finance Tax Time

Many people are buying a second home. They might do so to have a vacation home with the possibility of selling it at a substantial gain in the future. Another reason people buy a second home is to use it in the future as a primary home, perhaps in retirement. They might prefer to purchase the second home now to avoid the possibility of having to pay considerably more for it in the future.

What are the tax benefits and potential tax pitfalls in purchasing a second home? The first benefit is that the real estate taxes on a second home are deductible as an itemized deduction. However, a potential pitfall exists if the taxpayer is subject to the alternative minimum tax (AMT). Real real estate taxes are not deductible for AMT purposes.

The mortgage interest is also deductible as an itemized deduction on mortgage loans up to a maximum of $1,000,000 on loans used to acquire, construct, or substantially improve the taxpayer’s primary home and the taxpayer’s second qualified home. A refinancing of acquisition debt is considered acquisition debt to the extent that it does not exceed the balance before refinancing.

Another tax benefit for owning a second home is that the taxpayer may deduct interest on home-equity loans up to a maximum loan amount of $100,000. A home-equity loan is considered as an acquisition debt if the taxpayer uses it to make a substantial improvement to the primary home or second home. The loans may be secured by the primary residence and/or the second home. For tax purposes, a home-equity loan includes the excess of the balance of a refinanced acquisition loan over the balance before the refinancing unless the taxpayer uses the excess to make a substantial improvement to the home.

A tax pitfall is that the interest on a home-equity loan is generally not deductible for AMT purposes. An exception applies if the taxpayer uses the proceeds of the loan of the loan to make a substantial improvement to the property.

If a taxpayer rents a second home to a tenant for 14 or fewer days during the year, the rent income is not taxable. The taxpayer may still deduct the real estate taxes. The taxpayer may deduct the qualified mortgage interest as long as the taxpayer used the second home for personal purposes for a number of days that exceeds the greater of 14 days or 10 percent of the number of days the taxpayer rented the house to a tenant at a fair rental. If the taxpayer does not meet this test, the second home might be considered as rental property.

A potential tax pitfall on a second home is that any gain on the sale of a home that is not the taxpayer’s principal residence is taxable. It would be taxable as a capital gain because a personal use asset such as a second home is a capital asset.

The exclusion of gain up to $250,000 ($500,000 on a joint return) on the sale of the taxpayer’s home applies only to the sale of a home that that the taxpayer owned and used as the taxpayer’s principal residence for at least two of the five years before its sale. A taxpayer may have only one principal residence at a time.

A taxpayer could sell the primary home and exclude the gain up to the limit and then move into the second home and use it as a primary residence for at at least two of the five years before the taxpayer sells it. By doing so, the taxpayer could use the exclusion of gain provision on both homes. The potential to exclude the gain on the sale of both homes up to the limit using this strategy is a major tax benefit.

Another potential tax pitfall on owning a second home is that any loss on the sale of a home used as the taxpayer’s residence, whether as a primary home or as a second home, is not deductible because the loss is on the sale of an asset used for personal purposes.

An individual should consider many factors before buying a second home, such as cost, convenience, and potential gain. The tax benefits and potential tax pitfalls are some other key factors to consider before buying a second home.

Alan D. Campbell is a CPA in Arkansas and Florida and is self-employed primarily as an author of tax publications. He earned a Ph.D. in accounting with an emphasis in taxation from the University of North Texas. He is also admitted to practice before the United States Tax Court. He has published numerous articles on tax topics in professional journals. He is the co-author of the book Tax Strategies for the Self-Employed and the revision editor of CCH Financial and Estate Planning Guide, 15th edition. For more tax savings strategies, please see his blog: http://taxsavingsstrategies.blogspot.com

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When preparing your taxes, the goal is obviously to deduct every last penny you can. Many people are amazingly good at it. Just keep in mind you need receipts for the deductions.

List of Tax Records To Keep

Filling out and filing tax returns is really a quest to conquer the mountain. In this case, the mountain is your gross income. The IRS helpfully lets you know this by making you write it down right away and repeat it in various places on your 1040 form. How nice of them.

To conquer the mountain, you start shaving it down by claiming deductions. The more you can claim, the better off you are. Some people have lots of deductions that help in this regard. Others create lots of interesting deductions to do the same. Whatever you approach, keep in mind you need receipts to support those deductions should the IRS ask to see proof. Here is a list of common tax records you need to keep to support those deductions.

1. Mortgage Interest Payments. One of the great things about owning a home is the mortgage. Oh, wait. The great thing is the mortgage interest deduction, not the mortgage. To prove the amount you have been paying the piper, you should keep the form 1098 you receive from your lender each year. Given the fact the deduction is usually sizeable, make sure to keep it in a safe place.

2. Dependent Support. If you claim someone as a dependent, you may be in for a surprise. You need to be able to prove that you provide more than 50 percent of the support for that person. Happily married parents usually do not have problems, but the IRS likes to zing divorced parents on this issue. Keep records in the forms of receipts, checks and invoices in such a situation.

3. Home Repair Receipts. No, you do not have to show the receipts each year. The issue really comes up when you decide to sell your home. To cut your tax bill, you should claim all repairs and improvements you made since owning the home. Guess what, you need receipts to support those claims. In simple terms, save every receipt related to your home or risk losing the deductions.

4. Medical Expenses. Health care costs are out of control as we all know. If you are claiming deductions related to medical care, keep those receipts and bills.

Obviously, there are other areas where you need to keep receipts, but these are some of the more common places where people fall down on the job. In general, you should keep all the receipts for three years, but I suggest doubling that number. With home repair or improvement expenses, you need to keep them for five years after you get around to selling your home.

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Internal Revenue Service (IRS) allows the deduction of the discount points on your income tax return. Discount points which are one of the most important tax deductions to homebuyers are paid upfront to reduce the mortgage payment.

Calculate the Discount Points

Each point equals one percent of the principal. For example, a 2 discount points on $150,000 mortgage comes to $3,000 ($150,000 x 0.02). The Closing Statements shows how much is your discount points. If you do not see discount points, have no fear. Discount points are also called Loan Origination Fees, Maximum Loan Charges, or Loan Discount.

First Time Homebuyer Discount Points

For a first time buyer, IRS allows to claim the full amount of discount points on the year paid. For example, Joe bought his first home on 2005. In his closing statement, the discount points come to $3,000. Joe claims the full amount on Schedule A of his income tax return.

Discount Points on refinance without home improvement

The homeowners claim the full amount of discount points, when the homeowners refinance towards the improvement of the home. Without the home improvement, the homeowners claim the discount points over the life of the mortgage. For example, Joe refinances his home with a lower interest rate on a 25 year mortgage. The closing statement shows $3000 discount points. Joe claims $120 per year ($3,000 / 25 year mortgage).

Discount Points on refinance with home improvement

The discount points which are paid to improve the home is fully tax deductible on the year paid. The rest are claim over the life of the loan. For example, Joe refinances his home to add a swimming pool on a 25 year mortgage. He paid $20,000 to add a swimming pool. The total mortgage comes to $150,000. The closing statement states $3,000 discount points. Joe claims $400 ($20,000 swimming pool / $150,000 principal x $3,000) + $104 per year ([$3,000 discount points - $400 discount points of swimming pool] / 25 year mortgage).

If the homeowner has an outstanding discount points to claim, the homeowner claims the outstanding discount points on the year of refinance. For example, Joe has $2,000 discount points which are not claimed yet. Joe claims a total of $2,504 ($2,000 outstanding discount points + $400 swimming pool discount points + $104 per year discount points).

IRS yearly update

This article may or not contain the most current tax regulations, and laws. You may want to consider checking with your trusted Tax Advisor or IRS.

Dennis Estrada is a webmaster of mortgage calculators website which calculate the monthly payment, bi-weekly payment, affordability, refinance, annual percentage rate, discount points, and more.

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