Tax Rules and Planning with Residences
  
Sales of Principal Residences

For sales or exchanges of principal residences occurring after May 6, 1997, the law allows an exclusion of $250,000 of gain ($500,000 on a joint return). The old rollover rule is no longer the tax law of the land, including Massachusetts. The taxpayer must own and use the residence as a principal residence for at least two out of the last five years, and not have excluded gain within two years of the date of sale. For married couples, only one spouse need own or have title. Only one spouse needs to meet the ownership test, but both spouses must meet the use test. If one spouse does not meet the "use" test or the "gain within two years" test, the exclusion is reduced to the $250,000 limit. The exclusion also applies to sales of remainder interests(in principal residences).

If a home is sold without meeting the two out of five ownership and use test, and the sale is due to change of employment, health reasons, or unforeseen circumstances, they may prorate the exclusion.

Taxpayers who leave their residence to go into a licensed health care facility need only meet a one out of five year ownership and use test.

If the residence has been used as a home office within two years of the date of a sale, that fraction of the gain cannot be excluded from tax. Gain will be subject to ordinary rates, except to the extent of depreciation taken since May 7, 1997 in which case the tax rate is 25%.

If the residence has been rented within two years of the date of a sale, that fraction of the property cannot be excluded from tax. Gain is taxable as discussed above.

Vacation homes are fully taxable unless the taxpayers have met the "use" test.

Couples with more than one home need to treat residency and the exclusion consistently. For example, if the couple claims a home in a nontax state as their principal residence, any gain on sale of the home in the state with an income tax will be taxable if the "use" test is not met.

Single taxpayers with appreciation in excess of $250,000 must decide between tax savings(by marrying and meeting the use test before sale) and social/life style choices.

Couples that are separating or divorcing must watch the timing of the sale of principal residence. The general rule is that an individual is considered to met the use test, even if not living in the residence, during any period that the other spouse is granted use of the property under a divorce or separation agreement or instrument. If a spouse moves out of the house without an agreement or court order and the house is sold after two years, the nonresident spouse will not be able to use the exclusion.

If the court orders the residence be awarded to one of the spouses, that spouse will have only the $250,000 exclusion because the ownership test is not met.

A couple who move into a new residence and, instead of selling the old residence, rent it out for while waiting for the right buyer to come along, may still be able to exclude up to $500,000 of gain, provided they meet the "two out of five" rule. That means the closing date must be less than three years from the date of move-out.

Homeowners may sell a residence to a related party, such as a closely-held C or S corporation or a family limited partnership in order to make use of the exclusion.

Taxpayers are entitled under current law to buy, fixup and sell a principal residence every two years, completely tax-free, repeating the process until eventually a residence is mortgage-free.

The IRS has not yet ruled on when this flipping process becomes a business but when they do, the ruling could be retroactive.
 
Transfers Between Spouses

Under current law, no gain or loss is recognized on gift transfers between US citizen spouses. Such transfers are considered gifts, or transfers incident to divorce. Transfers incident to divorce must take place within one year of a divorce or be related to the cessation of the marriage. Transfers more than six years after a divorce may not be related, and a taxable gain may result, depending on the facts and circumstances.

While no gain or loss results from spousal transfers, there can be gift tax consequences. Transfers to a noncitizen spouse, other than incident to divorce, do not generally qualify for the gift tax marital deduction. Gifts to a noncitizen spouse are excluded from only up to $100,000, and only if it is a present interest and not a terminable interest.
 
Use of a Portion of a Residence As a Home Office

A portion of a residence may be used and deducted as a home office if it is used regularly and exclusively as the principal place of business for 1) meeting clients, customers, or patients; 2) for the majority of the income-producing activity; or 3) as a place for storing inventory. Also, if the majority of income is related to outside activities, then a "time" test is used...the majority of time working must be spent in the home office. If the home office is the only place of business, then the income or time tests are not applied.

Generally, a home office may only be deducted on a Schedule C - Profit or Loss from a Business or Profession. There is no deduction unless there is net income before the deduction sufficient to allow some or all of the home office expense. However, taxes and interest will be allowed even if they produce a net loss on Schedule C.

Commencing January 1, 1999, if there is no other fixed location of a business where the taxpayer conducts substantial administrative or management activities, the taxpayer may be entitled to a home office deduction for that portion of the residence used for administrative or management purposes.

Typical expenses, in addition to interest and taxes, include maintenance, repairs, utilities, and insurance. Snow removal and lawn care may be deducted if sufficiently related to the home office activities, such as frequent visits by clients, customers, or patients. Expenses may be allocated based on square footage or number of rooms. Basements and attics are typically not counted unless a portion of the space is used for business.

If a principal residence is sold while a home office is being used, a fraction of the gain will be taxable at ordinary income rates, except to the extent of depreciation taken since May 7, 1997 in which case the tax rate is 25%. Taxpayers who do not want to risk having gain on sale of a principal residence taxed at ordinary income rates should violate the exclusive use rule by using the home office for personal purposes as well as business purposes.
 
Vacation Homes

There are nearly seven million vacation homes in the US(1999), and their owners have nearly one-third as much income as the average American. Income can play a role in how much of loss a taxpayer can deduct if the home is considered to be a "rental property" under the rules.

At a minimum, the tax benefits of a second home are at least the straight-forward deductions of interest and taxes, and a taxpayer almost always gets those, if there are enough deductions to itemize on Schedule A and acquisition debt does not exceed $1 million(explained later).

First, the home must meet the definition of a "dwelling". Regulation 1.280 A-1(e) defines a "dwelling" as a house, apartment, condominium, mobile home, boat or similar property which provides basic living accommodations such as sleeping space, toilet, and cooking facilities. If a dwelling does not fit into the regulation¯s definition, interest and taxes cannot be deducted. If the dwelling is not a "second" dwelling(a third, fourth, fifth, etc.) then interest cannot be deducted.

If dwelling unit is rented for 14 days or less, then neither the rent is not reportable nor are the allocated rental expenses deductible. Allocable interest and taxes are still fully deductible as itemized deductions.

If the dwelling unit is rented for more than 14 days, and the dwelling is used for personal purposes for the greater of 14 days or 10% of the rental days, then the dwelling is treated as a home, and rental expenses are allocated and deducted against rental income, but no loss can be claimed. Another way of saying it is deductions are limited to gross rental income. Excess deductions may be carried forward and applied towards future rental income.

If the dwelling unit is rented for more than 14 days and the dwelling is not used for personal purposes for the greater of 14 days or 10% of the rental days, then the dwelling is treated as a rental property, and rental expenses are allocated and deducted against rental income and losses can be claimed. In this situation, interest expense attributable to the personal use is treated as investment interest, deductible only to the extent of net investment income.

If the dwelling is treated as a rental property, i.e. rented for more than 14 days and little personal use, then any loss is considered a passive loss and passive losses that generated by residential real estate are deductible up to a maximum of $25,000 per year until the phase-out range is reached. That means if a taxpayer¯s adjusted gross income(AGI) is between $100,000 and $150,000, the amount of loss deduction is reduced or phased out $1 for every $4 of AGI. In other words, any taxpayer with more than $150,000 of AGI gets no deduction of the rental losses until either AGI goes below $150,000 or the vacation home is sold.

There are several situations in which no loss will be currently deductible. If the vacation home/rental property is not actively managed by the taxpayer, no deduction is allowed. To be actively managed, the taxpayer must make all the decisions. The other situation is where the vacation home is rented for periods which average seven days or less. If the average rental period is seven days or less, the vacation home is considered to be like a hotel or motel, and they are treated as trade or business property. In this case, deductions for losses depend on whether the taxpayer materially participates in the "business". That means that taxpayers whose vacation homes are managed by third-party management companies will not be able to deduct any losses until the vacation home is profitable or is sold.

The IRS says that rental expenses should be allocated based on total use, both rental and personal, ignoring the days in the year the dwelling is not occupied. That method results in more personal interest, subject to the investment interest rule referred to above. The Ninth and Tenth Circuit Tax Courts(Massachusetts is in the 1st Circuit) have ruled that all months of the year may be counted in the denominator. Taxpayers should be aware that the IRS has not acquiesced to those decisions and will challenge that method through the audit process.

The IRS considers that family use counts as personal use, even if the family member is paying fair market rent, unless the family member is using the residence as their principal residence. Days spent doing maintenance and repairs are not counted.
 
Limits on Deductibility of Qualified Residential Mortgage Interest
Interest is fully deductible if the debt is either acquisition debt or home equity debt. Acquisition debt is debt, secured by a qualified dwelling(as defined above), and is not in excess of $1,000,000($500,000 on a married filing separate return). The debt proceeds must be traceable to costs incurred to acquire, construct, or substantially improvement a qualified residence(a principal dwelling and one other residence).

A residence under construction can be treated as a qualified residence for up to 24 months of construction, but only if the residence actually becomes a qualified ready-for-occupancy residence. Interest on a loan to acquire land does not become deductible until construction begins.

There is no limit on acquisition indebtedness if the debt was outstanding on or before October 13, 1987 which was then and still is secured by a qualified residence. That debt was "grandfathered" when the 1986 Tax Reform Act was enacted so no limit applies. However, pre- October 14, 1987 debt does reduce the $1,000,000 limit on post-October 13, 1987 debt.

Interest on debt secured by a residence other than your principal and one other residence(such as a third residence) can only be deducted if the loan proceeds were used for business or investment purposes.
 
Home Equity Loan Interest

Home equity loan interest is fully deductible as an itemized deduction on Schedule A as qualified residential interest. The definition of "home equity" is different from the banker/mortgage company definition. The tax rules define "home equity indebtedness" as indebtedness, other than acquisition debt, secured by the residence, and equal to the lesser of $100,000($50,000 on a married filing separate return) or the fair market value of the residence less the acquisition debt.

The use to which "home equity" loan dollars are put is not relevant for tax deduction purposes. Autos, personal expenses, and college costs, for example, are all perfectly tax-legal uses of "home equity" loans. The interest is fully deductible as an itemized deduction on Schedule A which may be a better after-tax deal then the typical nondeductible interest generated by a credit card, personal bank loan, or car loan. Interest on college loans is deductible from AGI, but the deduction is limited to certain caps($1,500 in 1999 increasing to $2,500 in 2001) and is allowed only for the first 60 months in which interest payments are required under terms of the loan.

Interest (on a home-equity loan) is not deductible if the proceeds of the loan are used to invest in tax-exempt securities.
 
Election to Forego Treatment as Home Equity Interest

Temporary Regulation 1.163-10T(o)(5) allows taxpayers to irrevocably elect to treat "home equity" debt as being other than "home equity" debt. Accordingly, interest is deducted according to how the loan was used. For example, if the loan was used to buy or start a business, the interest would be deductible as business interest in Schedule C - Income from a Business or Profession. This treatment will reduce net income for purposes of the self-employment tax, Section 179 deductions, and home office deductions. 

Refinancing Home Acquisition Debt

If a principal residence is refinanced, any interest on debt that exceeds the original acquisition debt plus home equity debt of $100,000 is nondeductible personal interest. Also, interest on that portion of a refinanced home mortgage that exceeds the original acquisition debt is an adjustment in computing the alternative minimum tax.

Points

The general rule is that points are amortized over the life of the loan. This rule applies to refinancings, to business debt, to rental property loans, vacation home loans, etc. There is only one exception: points paid on debt incurred to purchase, construct, or significantly improve a principal residence if the charging of points is an accepted practice in the area where the residence is located and they are not excessive in relation to normal practices. Taxpayers have the option of amortizing the points where otherwise entitled to deduct them, for example, where they cannot effectively itemize in the year of acquisition(because the standard deduction is higher). Unamortized points are deductible in full when the loan is paid or refinanced.

Points include loan origination fees, loan discount, and discount points, designated as such on the closing statement or paid separately and not deducted at closing. They also include seller-paid points. Other purchase costs and fees typically incurred at closing(shown on the closing statement) are not deductible. These include appraisal fees, processing fees, inspection fees, title insurance, recording fees, transfer taxes, legal fees, etc.
 
Dividing Residential Deductions in Divorce/Separation Situations

Assuming that the taxpayers reside in an equitable distribution state, which Massachusetts is, the division of interest and tax deductions is not always simple. Generally, the spouse who pays the expense from separately owned funds would be entitled to the deduction. Expenses paid from a joint account are assumed to be allocable 50% to each spouse. This also holds when one spouse no longer occupies the residence but the couple are still married. However, when the divorce is finalized, the nonresident spouse cannot deduct the interest because qualified residence interest is deductible when paid on a principal residence or on one other residence used by the taxpayer, which test the nonresident spouse cannot meet.

If the residence is awarded to the one of the spouses, the nonresident spouse gets an alimony deduction for the interest and taxes(and mortgage principal), and the occupant spouse has a wash, i.e. the interest and tax deductions almost offset the alimony income, except for the mortgage principal portion of the monthly payments.

If the residence is retained in joint name, the nonresident spouse deducts 50% of the payments as alimony and of the other 50%, the taxes are deductible, but the interest can only be deducted in the children still live in the house. That is because of a family attribution rule.
 
Estate Planning

By the year 2006, the exemption equivalent for each spouse will be $1,000,000, or $2,000,000 for a married couple. Unless it can be foreseen that there will be an estate tax "problem", the following discussion may not be relevant. However, given the ever-increasing value of housing in Massachusetts and certain other areas of the country, estate tax "problems" cannot automatically be ruled out.

Title is one key determinate of how the value of residence is handled in an estate. A decedent¯s gross estate includes the value of property held jointly at the date of death(DOD). Joint ownership includes tenancy by the entirety which is joint ownership between a husband and wife. If the title is joint tenants or tenants by the entirety, one half the value of the residence is automatically included in the estate of the first to die, regardless of which spouse paid for the residence.

The value of the jointly owned residence does not actually increase the taxable estate provided the one-half passing to the other spouse qualifies for the marital deduction. However, to be eligible for the marital deduction, four conditions must be met:

the property must be transferred solely to the decedent’s legal spouse,

the spouse must be a US citizen,

the transfer must vest full title, enjoyment, and control in the spouse, or the transfer must qualify for treatment as a qualified terminable interest, and

the residence must be included in the spouse’s gross estate.

The marital deduction is unlimited so it does matter whether the value of the residence is $100,000 or $10,000,000, the estate of the decedent does not pay a federal estate tax on the value of a residence under the conditions discussed above. It¯s the second spouse that may have the estate tax problem!!

Unmarried taxpayers who cohabit are not entitled to a marital deduction for either gift or estate tax purposes.

If a residence is owned jointly with a nonspouse(children, grandchildren, parents, etc.), then the value of the residence is 100% includible in the estate of the first joint tenant to die, except to the extent that the surviving tenant can show how much he or she paid or contributed to the original purchase cost(contributions for improvements do not count for estate inclusion but do count as cost if the resident is sold). If the residence was originally inherited or gifted, then only the actual ownership interest of the first joint tenant to die is includible.

As mentioned above, property passing to a spouse who is not a US citizen does not qualify for the marital deduction. However, the property can qualify if it passes through a trust known as a Qualified Domestic Trust(QDOT). A QDOT is a trust subject to the US laws, having at least one bank or financial institutional trustee who withholds and pays over to the US Treasury prepaid estate taxes on the death of the second spouse. This arrangement protects the revenue from a resident alien spouse who could leave the country to avoid estate taxes.

Taxpayers who transfer a principal or a second residence to Qualified Personal Residence Trust(QPRT) may be able to get the residence out of the estate at a significantly reduced value. That¯s because the fair market value at the date of transfer is discounted using the Section 7520 rate for the term of the trust. There are some conditions:

there can be only one residence per trust

the house can only be occupied by the grantor/term holder

trust income, if any, can only be distributed to the grantor

the grantor must outlive the term of the trust

at the end of the term, the house must be rented for fair market value

If the taxpayer(s) fail to survive the trust term, the residence comes back into the estate at its fair market value at date of death. In that case the basis of the residence is "stepped up" to the fair market value at date of death(or alternate valuation date). If the taxpayer(s) do survive the trust term, there is no stepup in basis to fair market value. Usually, this technique is used only with a second home.

A well-to-do taxpayer may wish to make a charitable donation of a residence, especially in situations where either there is no next-of-kin or the potential heirs are sufficiently endowed with assets. Typically, a charitable remainder annuity trust would be set up and the residence transferred to the trust. The taxpayer gets to take a charitable contribution deduction in the year of the gift, computed from IRS valuation tables as the value of the remainder interest given the donor¯s life expectancy.
 
Cost Basis

Generally, basis is the cost of acquiring a residence. This typically includes the purchase price plus the various closing costs shown on the closing statement, such as fees for attorneys, bank processing, inspecting, recording, abstracts, and surveys(to name a few), together with transfer taxes, title insurance, commissions, and the like. Prorata taxes and interest are not added to basis, but instead are deducted as an itemized deduction on Schedule A. Closing costs that are not added to basis include various insurance premiums, PMA insurance, utility charges, rent, and various fees or service charges for occupying the home pending closing.

For taxpayers who inherit a home, the basis would be the fair market value or the amount included in the estate tax return Form 706 which should be available from the executor. If the estate was not large enough to require the filing of a return, a taxpayer will need to obtain an appraisal as of the date of death.

If the home was gifted to a taxpayer, he or she will need to obtain a copy of the gift tax return. If any gift tax was paid, that portion of the gift tax attributable to the appreciation in the home over the original cost can be added to the original cost to obtain the basis. The basis is not the fair market value at the date of the gift.

Additions and improvements should be added to basis and copies of canceled checks, invoices, bills, receipts, or other documentation should be kept in a file, ready to show the IRS should they audit a sale transaction. There are too many capitalizable additions and improvements to list here, but certainly new additions, rooms, flooring, central air conditioning, central vacuum systems, patios, landscaping, lawn watering systems, alarm systems, driveways, and appliances that will stay when the house is sold are brief examples. Normal repairs and maintenance are not added to basis. Depreciation allowed or allowable must be subtracted as would any gain from sale of an old home which was not taxed.