Category Archives: Mortgage

Deducting Interest Paid

Among the itemized deductions on Schedule A of Form 1040, you’ll find “Interest You Paid.” As you get your records together for tax preparation, you should realize that not all interest can be deducted on your return. Interest you paid last year on credit card debt generally isn’t deductible, for example.

Interest deductions on Schedule A fall into two categories. You probably can deduct interest on debt related to your home, and you might be able to deduct interest on debt you incurred as part of your investment activity.

Mortgage interest debt

If you have borrowed money to buy, build or improve your home, you can deduct some or all of the interest you paid during 2015. A “home” can be a house or an apartment you own—even a trailer or a boat, as long as it has cooking, sleeping and toilet facilities. You can deduct the interest on two such homes.

Example 1: Warren Young owns a single-family home as well as a cabin on a nearby lake, which he uses on weekends. If Warren has mortgages on both homes, he typically can deduct all the interest he paid on those loans in 2015.

Going forward, suppose that Warren gets married in 2016, and his wife also owns a home. Assuming the couple files a joint income tax return in 2016, what mortgage interest can this three-home couple deduct?

They’ll be limited to the interest paid on two homes. If one home is debt-free, the couple can deduct the interest paid on the two home loans. If all three homes are mortgaged, the couple can deduct the interest on the two homes with the highest interest payments during the year.

Home Equity Debt

In addition to home acquisition debt, there is a second category of debt, home equity debt, which may give rise to deductible interest. Interest on home equity debt, which includes loans secured by the home but not necessarily used for any specific purpose, is deductible for balances up to $100,000 ($50,000 for married taxpayers filing separately).

Example 2: Assume that Warren Young’s mortgages on his primary home and his vacation home total $900,000, and Warren also has a home equity loan secured by his primary home of $50,000. Warren can deduct all the interest he pays on both the mortgage loan and the home equity loan.

Million dollar limit

The deduction for interest paid on home acquisition debt is limited to interest paid on $1.0 million of debt ($500,000 for married taxpayers filing separately) and, as noted previously, the deduction for home equity debt is limited to interest paid on $100,000 of debt ($50,000 for married taxpayers filing separately). However, the IRS has ruled that it will treat home acquisition debt as home equity debt to the extent it exceeds $1 million or $500,000 for married taxpayers filing separately, effectively increasing the limit on home acquisition debt to interest paid on $1.1 million of debt or $550,000 of debt for married taxpayers filing separately.

Example 3: Assume that Warren Young has an $800,000 balance on his primary home mortgage plus a $400,000 mortgage on his vacation home for a $1.2 million total, and he has no home equity debt. Warren’s deduction on Schedule A would be limited to the interest paid on $1.1 million of this debt. (If you are in such a situation, our office can calculate the allowable deduction.)

Don’t forget the AMT

The alternative minimum tax (AMT) rules for deducting mortgage interest are more restrictive than the regular tax rules. If you expect to be subject to the AMT, our office can determine whether the interest on home acquisition debt or home equity debt is deductible when calculating your AMT.

Investment interest

If you borrow money to make investments, the interest you pay on the loan may be deductible on Schedule A. Often, interest paid on a margin account at a brokerage firm will be classed as investment interest, but that’s not the only possible source. If you borrow to buy a parcel of land that you think will gain value, the interest you pay can be investment interest.

On Schedule A, investment interest can be listed up to the amount of taxable investment income you report.

Example 4: Stan Rogers had $1,200 of taxable investment income from bond interest in 2015 and $1,500 of interest on a margin loan. Stan can deduct $1,200 of margin interest on Schedule A of his tax return for 2015, offsetting his $1,200 in taxable investment income. The unused $300 of investment interest expense can be carried over to a future year in which Stan’s taxable investment income exceeds his investment interest expense.

Note that the situation would be more complicated if all of Stan’s 2015 investment income came from dividends instead of interest. Assuming those dividends qualify for low tax rates of 0% to 20%, which generally is true, the dividends would not count as investment income for this purpose. In this situation, Stan could not deduct any of his investment interest expense.

However, Stan could elect to treat his dividends as nonqualified, which are taxable at higher rates. Then, Stan could deduct his investment interest expense.

Net capital gains (that is, net long-term capital gain less short-term capital losses) from the disposition of investment property are also not included in investment income. Like dividends, a taxpayer may elect to have net capital gains included in investment income, but the gains included in net investment income will be taxed at the higher ordinary tax rates.

There are times when electing to include dividends or net capital gains in income makes sense; if you have that choice, our office can help you make the most tax-effective decision.

Trusted Advice

Naming names

  • For many homeowners, mortgage interest will be reported annually to the IRS by the lender on Form 1098.
  • However, that may not be the case if the seller “takes back” a loan, effectively lending part of the purchase price to the buyer.
  • Assume the buyer makes monthly payments to the seller, on this loan. Payments include interest and some reduction of the principal.
  • Then, the buyer probably will be entitled to deduct the interest paid.
  • The buyer should put the seller’s name, address, and tax identification number on Schedule A of Form 1040.

Deducting Taxes Paid

When you file your 2015 federal income tax this year, you can take a standard deduction. For 2015, that’s $6,300 for single taxpayers and for married individuals filing separately; $12,600 for couples filing jointly and for certain widow(er)s; and $9,250 for those filing as heads of household. The beauty of taking the standard deduction is that it’s simple: There’s no need to gather information and scant risk of triggering an audit.

However, taking the time to itemize deductions can be a tax saver. If your itemized deductions exceed the standard amounts, you’ll generally come out ahead by listing them on Schedule A of Form 1040. Indeed, the amount you can claim under “Taxes You Paid” may be enough to justify itemizing.

Property tax

You can itemize the property tax you pay for your home. If you have a second home, the tax on that property also can be deducted. In fact, you can deduct any amount of tax you pay on any number of homes that were not used for business, even if they’re in different states or out of the United States.

The key here is to deduct the payment for the year in which it was paid. If you had a property tax payment due in January or February 2016, for instance, and you sent in the payment in December 2015, that amount can be an itemized deduction in 2015.

If you make monthly mortgage payments on a home, a portion of each payment might go into an escrow account for eventual forwarding to the property tax collector. In this scenario, the property tax payments are deductible for the year in which the money is actually paid out of the escrow account to the taxing authority.

So-called “local benefits taxes” paid by property owners may or may not be deductible, depending on how the money is used. Our office can determine whether you can deduct such taxes. You also may be able to deduct personal property tax, assessed on the value of items, such as boats or cars.

To be decided

State and local income tax you paid also can be deducted on Schedule A. That includes amounts withheld from paychecks as well as any estimated state or local estimated income tax you paid during the calendar year.

For the past decade, taxpayers have had the option of deducting state and local sales tax instead of state or local income tax, if that provides a greater deduction. This provision has expired several times, only to be renewed. As of this writing, the sales tax deduction opportunity is not in effect for 2015, but it’s likely that Congress will have restored it by the end of the year.

A sales tax deduction obviously appeals to residents of states or localities with no income tax. If you live in an area with an income tax—and if you are itemizing deductions—you should see which choice provides the greater tax savings.

Example 1: Marge Collins pays enough property tax to make itemizing worthwhile. When getting her records together for tax preparation, Marge discovers that she paid a total of $3,000 in state income tax in 2015. Assuming the sales tax deduction has been restored for 2015, Marge should see how much sales tax she paid last year. If the total exceeds $3,000, she probably should deduct sales tax instead of state income tax.

How can Marge determine the amount of sales tax she paid, throughout 2015? One way is to go through all of her receipts for the year, and calculate the sales tax she paid on purchases.

Many people don’t keep all their receipts, though. If you’re in that category—and if the rules for 2015 are the same as they were for 2014—you can use the optional sales tax table provided by the IRS, in the instructions to Form 1040.

That table shows the amount of the sales tax you’re estimated to have paid in the relevant year, depending on your income, where you live, and the exemptions you claim. Note that “income,” for this purpose, includes not only your adjusted gross income but also inflows such as tax-exempt interest and nontaxable Social Security benefits. The greater your income, the more sales tax you’re presumed to have paid.

What’s more, the IRS tables don’t assume you have made any large purchases. Thus, the resulting amount from the tables can be increased by any sales tax you paid for a car (bought or leased), motorcycle, boat, airplane, motor home, or similar items.

Last year, a Sales Tax Deduction Calculator was offered at irs.gov. The IRS asked for a few simple entries in order to illustrate the amount of state and local sales tax you could claim. Assuming the sales tax deduction is reinstated for 2015, this calculator may help you get your records ready for tax preparation.

Trusted Advice

 Not Deductible

 Following is a list of taxes and other expenses that are not deductible taxes:

  • Federal income and most excise taxes
  • Social Security, Medicare, federal unemployment (FUTA), and railroad retirement (RRTA) taxes
  • Customs duties
  • Federal estate and gift taxes
  • Tax on gasoline
  • Car inspection fees
  • Assessments for sidewalks or other improvements to your property
  • License fees (marriage, driver’s, dog, etc.)

 

2015 Year-End Estate Tax Planning

In 2015, the federal estate tax exemption is $5.43 million. With little planning, a married couple can pass up to $10.86 million worth of assets to heirs, so no estate tax will go to the IRS. Those numbers will increase in the future with inflation.

With such a large exemption, you may think that estate tax planning is unnecessary. However, nearly half of all states have an estate tax (paid by the decedent’s estate) or an inheritance tax (paid by the heirs) or both. The tax rate goes up to 16% in many states, or even higher in some.

What’s more, state estate tax exemptions tend to be lower than the federal exemption; in some states, there is virtually no exemption for certain estates. Therefore, you may find year-end estate tax planning to be worthwhile, even if you don’t anticipate having an estate over $5 million or $10 million.

Employing the exclusion

 In terms of year-end planning, anyone with estate tax planning concerns (federal or state) should consider year-end gifts that use the annual gift tax exclusion, which is $14,000 in 2015. That is, you can give up to $14,000 worth of assets to any number of recipients, with no tax consequences. You don’t even have to file a gift tax return.

Married couples can give up to $28,000 per recipient, from a joint account, or $14,000 apiece from individual holdings. Larger gifts probably won’t be taxed because of a generous lifetime gift tax exemption, but you’ll be required to file a gift tax return and there could be future tax consequences.

Example: Walt and Vera Thomas have two children. In 2015, Walt can give $14,000 worth of assets to their son Rick and $14,000 to their daughter Ava. Vera can do the same, moving a total of $56,000 from their taxable estate.

Similar gifts might be made to parents you’re helping to support. As explained previously in this issue, giving appreciated stocks and stock funds to loved ones may be an effective way to reduce exposure to any market retreat.

Whatever your purpose, keep in mind that there is no spillover from one year to the next. If you miss making $14,000 annual exclusion gifts in 2015, you can’t double up with a $28,000 exclusion gift in 2016. Moreover, make sure that gifts are completed—checks must be cashed—by December 31. Therefore, you should put your plans for year-end gifts in motion well before year end.

Passive Activity Losses From Rental Property

In these times of high stock prices and low bond yields, investors might be thinking about rental property. Such investments can pay off, in the right situation. Before you make any decisions, though, you should be aware of the tax implications, especially the passive activity loss rules.

Despite the language, those rules don’t apply to familiar investments that might seem passive, such as buying corporate stocks or government bonds. Rental property is deemed to be a passive activity, so the passive activity rules typically apply to individual investors acting as landlords. Investing in real estate may deliver untaxed income, but deducting losses can be challenging. (The rules are different for individuals who are real estate professionals, but specific qualifications must be met.)

Depreciating while appreciating

Investment property owners can take depreciation deductions, even if the property is gaining value. What’s more, this deduction requires no cash outlay.

Example 1: Brett Parker buys investment property for $400,000 and collects $1,800 in monthly rent. Thus, his annual income is $21,600. His out-of-pocket expenses (interest, insurance, maintenance) total $12,000, so Brett collects $9,600 in positive cash flow this year, in this hypothetical example.

Suppose that Brett can claim $16,000 of depreciation deductions as well. Now Brett reports $21,600 of income and $28,000 ($12,000 plus $16,000) of expenses from the property, for a net loss of $6,400.

Brett has reported a loss, so no income tax will be due on his rental income. For Brett, this would be $9,600 of tax-free cash flow. If he also can deduct the $6,400 loss from his other income, the tax treatment would be even better.

Loss lessons

In one scenario, Brett has another rental property that generates $7,500 of net income. This passive activity income from Property B can be offset by the $6,400 loss from Property A, so Brett reports a taxable profit of only a net $1,100.

However, many people won’t have passive activity income to offset, or their passive activity loss will be greater than that income. In those cases, deducting the loss from other income is possible, if certain conditions are met.

For one, investors must play an active role in managing the property. That doesn’t mean you’ll have to screen tenants or fix toilets. You can hire a property manager but still play an active role, for this purpose, by making decisions involving the property’s operation or management.

Another condition of deducting losses from a rental property relates to your adjusted gross income (AGI). A deduction as great as $25,000 per year is permitted, but the deduction phases out as your AGI climbs from $100,000 to $150,000. That phaseout range is the same for joint or single filers.

Example 2: Joan, Janice, and Jennifer Smith are sisters; they each own rental property that shows a loss this year, after deducting depreciation. Joan’s AGI is $95,000, so she can deduct her rental property loss this year, up to the $25,000 maximum. Janice’s AGI is $155,000, so she can’t deduct any loss from her rental property. (However, because Janice reports a loss, she also won’t owe tax on the cash flow she receives.)

Suppose that Jennifer’s AGI is $130,000. She is 60% ($30,000/$50,000) through the phaseout range, so she’ll lose 60% of her maximum loss deduction. Jennifer can deduct rental property losses up to $10,000 (40% of the $25,000 maximum) but won’t be able to deduct larger losses.

Keep in mind that rental property losses you can’t deduct currently are not gone forever. Unused losses add up, year after year, to offset future passive activity income. If you have unused losses from prior years, you can use them when your future AGI permits. Moreover, when you sell the property, you can use all of your banked losses then to reduce the tax you’ll owe on the sale.

Nevertheless, a tax deduction you can take immediately is more valuable than a deduction years in the future. If your AGI is between $100,000 and $150,000, actions such as taking capital gains or converting a traditional IRA to a Roth IRA can raise your AGI and reduce current deductions for rental property losses.

Trusted Advice 

Passive Procedures

  • Passive activities include trade or business ventures in which you do not materially participate; that is, you are not involved in the operation of the activity on a regular, continuous and substantial basis.
  • Rental activities such as rental real estate ventures generally are passive activities for the rules on passive activity losses.

The passive activity rules apply to individuals, estates, trusts (other than grantor trusts), personal service corporations, and closely held corporations as well as to the owners of grantor trusts, partnerships, and S corporations.

Passive Activity Losses From Rental Property

In these times of high stock prices and low bond yields, investors might be thinking about rental property. Such investments can pay off, in the right situation. Before you make any decisions, though, you should be aware of the tax implications, especially the passive activity loss rules.

Despite the language, those rules don’t apply to familiar investments that might seem passive, such as buying corporate stocks or government bonds. Rental property is deemed to be a passive activity, so the passive activity rules typically apply to individual investors acting as landlords. Investing in real estate may deliver untaxed income, but deducting losses can be challenging. (The rules are different for individuals who are real estate professionals, but specific qualifications must be met.)

 

Depreciating while appreciating

 Investment property owners can take depreciation deductions, even if the property is gaining value.
What’s more, this deduction requires no cash outlay.

Example 1: Brett Parker buys investment property for $400,000 and collects $1,800 in monthly rent.
Thus, his annual income is $21,600. His out-of-pocket expenses (interest, insurance, maintenance)
total $12,000, so Brett collects $9,600 in positive cash flow this year, in this hypothetical example.

Suppose that Brett can claim $16,000 of depreciation deductions as well.
Now Brett reports $21,600 of income and $28,000 ($12,000 plus $16,000) of expenses from the property, for a net loss of $6,400.

Brett has reported a loss, so no income tax will be due on his rental income. For Brett, this would be $9,600 of tax-free cash flow. If he also can deduct the $6,400 loss from his other income, the tax treatment would be even better.

Loss lessons

In one scenario, Brett has another rental property that generates $7,500 of net income. This passive activity income from Property B can be offset by the $6,400 loss from Property A, so Brett reports a taxable profit of only a net $1,100.

However, many people won’t have passive activity income to offset, or their passive activity loss will be greater than that income. In those cases, deducting the loss from other income is possible, if certain conditions are met.

For one, investors must play an active role in managing the property. That doesn’t mean you’ll have to screen tenants or fix toilets. You can hire a property manager but still play an active role, for this purpose, by making decisions involving the property’s operation or management.

Another condition of deducting losses from a rental property relates to your adjusted gross income (AGI). A deduction as great as $25,000 per year is permitted, but the deduction phases out as your AGI climbs from $100,000 to $150,000. That phaseout range is the same for joint or single filers.

Example 2: Joan, Janice, and Jennifer Smith are sisters; they each own rental property that shows a loss this year, after deducting depreciation. Joan’s AGI is $95,000, so she can deduct her rental property loss this year, up to the $25,000 maximum. Janice’s AGI is $155,000, so she can’t deduct any loss from her rental property. (However, because Janice reports a loss, she also won’t owe tax on the cash flow she receives.)

Suppose that Jennifer’s AGI is $130,000. She is 60% ($30,000/$50,000) through the phaseout range, so she’ll lose 60% of her maximum loss deduction. Jennifer can deduct rental property losses up to $10,000 (40% of the $25,000 maximum) but won’t be able to deduct larger losses.

Keep in mind that rental property losses you can’t deduct currently are not gone forever. Unused losses add up, year after year, to offset future passive activity income. If you have unused losses from prior years, you can use them when your future AGI permits. Moreover, when you sell the property, you can use all of your banked losses then to reduce the tax you’ll owe on the sale.

Nevertheless, a tax deduction you can take immediately is more valuable than a deduction years in the future. If your AGI is between $100,000 and $150,000, actions such as taking capital gains or converting a traditional IRA to a Roth IRA can raise your AGI and reduce current deductions for rental property losses.

Trusted Advice

Passive Procedures

  • Passive activities include trade or business ventures in which you do not materially participate; that is, you are not involved in the operation of the activity on a regular, continuous and substantial basis.
  • Rental activities such as rental real estate ventures generally are passive activities for the rules on passive activity losses.
  • The passive activity rules apply to individuals, estates, trusts (other than grantor trusts), personal service corporations, and closely held corporations as well as to the owners of grantor trusts, partnerships, and S corporations.