CHAPTER 5 Deductions around the House

THE AMERICAN DREAM—OWN YOUR own home, a car or two, a big screen television, and several mobile communications devices. It’s true, not everyone ends up buying a home, but those who do are entitled to a whole raft of itemized deductions and, perhaps, even tax credits. First, let’s take them in the order they appear on Schedule A. Then we’ll explore the potential credits and how to snag them.

Tip #37:

Real property taxes. Deduct the real estate taxes you pay on all your properties, unless some of those taxes are deducted elsewhere. This split deduction might happen if you use a home partially for business (Form 8829) or rent out a room or half a duplex (Schedule E). Read your property tax bill carefully because not all the charges are deductible as property taxes. For instance, your bill might include special assessments for bonds, or might include sewer fees or payments for city or county improvements. While you pay for those things along with your property taxes, they are technically not deductions. (Shhh . . . I have never seen the IRS adjust for this on audit.) Some states might have special charges that look like nondeductible assessments or fees but are deductible. For instance, California has something called Mello-Roos fees. In February 2012, the IRS ruled that these are deductible as property taxes. Note: If you pay your taxes to your lender as part of your monthly payment, they will give you a year-end statement showing the taxes, property insurance, and PMI (mortgage insurance) paid on your behalf during the year.

Tip #38:

In order to deduct the property taxes, you must own the property and you must be the person making the payments. Gosh, that seems obvious, doesn’t it? Why bring it up? Because sometimes people don’t have enough of their own credit to buy their homes. Someone else needs to get the loan for them (like a parent, relative, or an amazingly good friend). So their name isn’t on title—or on the loan. Uh oh. That means the person on title doesn’t get the property tax deduction because they weren’t the ones paying the property tax. And you don’t get the deduction because you’re not on title. Is there a solution to this dilemma? Yes there is. Stay tuned to Tip #50, when we talk about mortgages.

Tip #39:

What are the most overlooked, but deductible, property taxes? Property taxes assessed as part of your time-share fees and as part of your community’s common area fees. Some sets of fees are pretty low. In other areas, common area fees are quite high, and you can pick up several hundred dollars (or thousands) by getting the reports from your management companies.

Tip #40:

Escrow is another source of real estate taxes paid. When buying or selling real estate, read the HUD-1 summary (or escrow closing statement). You may find that you have paid taxes through the escrow by repaying the sellers for taxes they paid for part of the year. On the other hand, you might learn that they are paying you in advance for their share of the taxes due later in year. For example, many states collect taxes around April and December. The April payment covers the period from January through June. The December payment covers taxes due from July through December. So if the sale takes place in September, the buyer ends up paying the June–September property taxes as part of the December bill. In escrow, the seller makes up for that by paying the buyer for those June–September property taxes. That means the buyer reduces his or her property tax expense at the end of the year. The opposite happens if the property is sold in the first half of the year. The buyer reimburses the seller for the taxes he or she paid in the beginning of the year and gets an extra property tax deduction as a result. Here’s where you find this information on the HUD 1 statement: http://portal.hud.gov/hudportal/documents/huddoc?id=1.pdf (see image).

Tip #41:

Personal property taxes. Typically, these are the annual fees you pay to your state’s department of motor vehicles based on the value of your auto, boat, ATV, Jet Ski–type things, motorcycles, snowmobiles, and other such toys and vehicles. If the fee is not based on value but is simply a processing-type fee—the cost is not deductible. Often your license fee includes such base fees or special fees for vanity plates. Those costs are not deductible either. Incidentally, in the many decades that I have been preparing tax returns, this is one of the most often overlooked deductions. For some folks, it may not be much. But for others, when you look at all the vehicles . . . it adds up. Especially since motor home and RV licenses can be deducted on this line (line 7 Schedule A). Note: If you use the car for business, only report the personal use percentage of these taxes. For instance, if you use the car 80 percent for business, and the tax is $75, only report $15 on Schedule A.

Tip #42:

Sales taxes. Although these aren’t around-the-house-type taxes, let’s talk about them anyway—especially since we buy things for the home and pay sales taxes. There’s a strategy to use with these deductions. If at all possible, deduct your sales taxes instead of your state income taxes. Why? There are several reasons:

• When you deduct your sales taxes, you don’t have to report your state income tax refund as income on the following year’s tax return.

• You don’t have to track all the sales taxes you paid. Just use the IRS’s Sales Tax Calculator: https://www.irs.gov/Individuals/Sales-Tax-Deduction-Calculator.
• Your tax software might even have the information for your state—just add in the extra sales tax percentage your county or parish charges.
• In addition to the sales tax tables, where the tax is based on your AGI, you can add the sales taxes paid on big-ticket items like cars, boats, RV, expensive electronics, Rolex watches, and so on.
• Some states don’t even have income taxes, so sales taxes are your only option.

Note: The sales tax deduction is one of those tax provisions that have been expiring every year. This is now a permanent part of the Internal Revenue Code as Section 106 of the PATH Act of 2015. Please see Bonus Tip #270 for more details.

Tip #43:

State income taxes. Naturally, if your state income taxes are much higher than the sales taxes you paid, use this deduction. When you end up getting a refund on your state tax return, after itemizing the taxes on Schedule A, you will need to report all or part of your state refund as income. Why only part of it? Well, if you didn’t get any benefit from the state income tax deduction, you don’t need to pay taxes on refund, either. There are detailed instructions for line 10 of Form 1040 (https://www.irs.gov/instructions/i1040gi/ar01.html#d0e3584). Generally your software will do this computation for you if you give it enough information about last year’s tax return.

Tip #44:

Good news: if you did not itemize in the year for which you received your refund, the state refund is not taxable. For instance, let’s say you filed several years’ tax returns in 2015—you filed 2012, 2013, and 2014. Suppose you didn’t itemize in 2012 and 2013, but your state refund is $10,000. None of that refund is taxable. But let’s pretend that you itemized in 2014 and got the full benefit of your state income tax deduction. In that case, the $5,000 refund you received for 2014 is income to you in 2015 even though you may have a received a total of $15,000 in state refunds during 2015.

Tip #45:

Here are three commonly overlooked state tax deduction opportunities:

• If you were making state-estimated tax payments, remember the January payment for the fourth quarter. Even though the payment you made in the tax year you are filing was for last year, you get to deduct it. Why? You paid it in the current tax year.

• Did you have a state overpayment on your tax return that you applied toward the following year’s taxes? That’s considered a payment you made in the current year. For instance, you applied your 2014 state tax refund to your 2015 state taxes. That payment is considered made in 2015.

• Did you pay a balance due to the state when you filed your tax return? Remember to add that to your total state taxes paid. For instance, you paid your state $532 when you filed your 2014 income tax return in April of 2015. That payment is made in 2015. Oh, and do remember to add it to your total estimated payments for 2015. A lot of people forget to include that.

Tip #46:

Here are two more “state” tax deductions that most people don’t know about at all:

• Taxes imposed by Indian tribal governments are deductible. Though I would bet that people living on reservations know this one applies to them, an excerpt from IRS Publication 17 reads:
“Indian tribal government. An Indian tribal government recognized by the Secretary of the Treasury as performing substantial government functions will be treated as a state for purposes of claiming a deduction for taxes. Income taxes, real estate taxes, and personal property taxes imposed by that Indian tribal government (or by any of its subdivisions that are treated as political subdivisions of a state) are deductible” (https://www.irs.gov/publications/p17/ch22.html#en_US_2014_publink1000173139).
• Foreign income taxes paid are deductible. You may have paid them as deductions from dividends, from your pension, or from the foreign equivalent of Social Security income. Be sure to convert the foreign currency to US dollars. You can look up the IRS’s approved currency conversion rates on their website here: https://www.irs.gov/Individuals/International-Taxpayers/Yearly-Average-Currency-Exchange-Rates. Or you can use the Oanda site to get values on specific days or averages for a year or so: http://www.oanda.com/currency/.
- ◦ Incidentally, you have a choice about those foreign taxes. You may take them as a deduction here on Schedule A or you may choose to take them as a tax credit using Form 1116, Foreign Tax Credit.

Enough about taxes! Let’s move on to more interesting things. Like . . . interest!

Tip #47:

Mortgage interest paid. This looks pretty simple, doesn’t it? Yet I managed to teach an entire two-hour course on the subject (http://www.cpelink.com/self-study/home-mortgage-interest-deductions/6097). The IRS publishes a 17-page booklet on the subject—IRS Publication 936 (https://www.irs.gov/pub/irs-pdf/p936.pdf). Let me just give you the high points here. First, the good news: the bad news I am about to give you probably won’t impact you. OK, here’s the bad news: your mortgage interest deduction is limited in several ways.

• You may only deduct the interest on acquisition debt—the amount of the mortgage you took out when you bought the house. Plus any mortgage you took out to pay for repairs or remodeling.
• In addition, you may deduct the mortgage up to another $100,000 of a home equity line of credit (HELOC). This money may be used for anything—like debt consolidation or the vacation of a lifetime. It doesn’t matter what. The loan must be secured by the home.

• Often, when the value of the home increases dramatically or interest rates plunge, people refinance. When you refinance, your mortgage interest deduction is limited to the interest on the balance of the loan at the time of the refinancing plus that HELOC value of $100,000. For instance, your original loan was for $200,000 five years ago, and today the loan balance is $175,000. The house is now worth $400,000. You get a new 80 percent loan for $320,000 and include the points and refinance fees in the new loan, taking the balance to $325,000. Since the interest rates are lower, your payments don’t go up very much—but you’re able to pull out $145,000 in cash. Suppose this is the only loan on the house. You may deduct the interest on this part of the mortgage only:

The $175,000 balance left on the original loan
The $100,000 allowable HELOC
Total: $275,000 Allowable Mortgage Balance

What happens to the interest on the other $50,000 ($325,000 loan, less the deductible mortgage value of $275,000)? Nothing. No deduction. No carryforward. Nothing. So please take this into account when refinancing. If you are ever audited, the IRS will catch this error and may go back for up to three years to recover taxes due.

• $1 million is the limit of the total amount of mortgage balance on which you may deduct interest. That, plus the $100,000 HELOC. So . . . in total, you may deduct mortgage interest expense on up to $1,100,000. This limit is not per house; it is for all the homes you might own. The IRS had a field day with this limit several years ago. They tested how well taxpayers were adhering to this rule by auditing taxpayers who owned property in Santa Barbara, California, particularly in the Montecito area. Estates in that area sell for millions of dollars. Most of the taxpayers who were audited ended up having taken the full mortgage deduction instead of limiting the interest expense to $1,100,000. Their tax professionals were furious at the IRS (uh, actually at themselves for getting caught in this major blunder). But . . . the law is the law.

• Yet another limit—unlike real property taxes, where you may deduct the property taxes on all your properties, you are only entitled to deduct the interest on up to two homes. So people who have multiple homes must pick the two homes producing the highest interest deduction for the year. Don’t worry, you may switch your choices each year. TaxMama suggests that you use the homes with the highest interest rate or highest total interest expense.

• One more limit—Alternative Minimum Tax (AMT) rears its ugly head. Take a look at the AMT form, Form 6251 (https://www.irs.gov/pub/irs-pdf/f6251.pdf). When you deduct any HELOC interest at all, you need to enter that amount on line 4.

This is not an adjustment that your tax software will pick up automatically—most professional software doesn’t even pick it up. This entry must be made manually. (Though, if the software companies would just create an input field for HELOC interest, the software would be able to do this for you.)
• Can you get around these deduction limits by moving some of the interest to your office in home (Form 8829) or to the rental form (Schedule E) when you rent out space in your home? Nope. I thought it would be a terrific loophole and researched this. Sad to say, no matter where you try to move that interest on your personal residence(s), you are still limited to the acquisition debt + $100,000 or to the $1,100,000 total loan balance.

• To top it all off, if you managed to snag a loan with a really good interest rate, like 4 percent or less—a married couple probably won’t have enough interest expense to allow you to itemize in the first place. (Average US mortgage debt is around $156,000 [https://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/] × 4 percent = $6,240. Add in about $2,000 in property taxes and your potential itemized deduction is under $10,000, including state taxes. The standard deduction for a couple filing jointly is more than $12,000.)

Tip #48:

Finally, some good news—here’s how you can increase the deduction for mortgage interest after you refinance. Suppose you realized that you had $200,000 in equity that you could pull out of your mortgage. This is a great way to get your hands on some cash without having to pay tax on the earnings. You decided that you can use that money as a down payment on a rental property. There is a special provision (https://www.irs.gov/publications/p936/ar02.html#en_US_2014_publink1000229898) that lets you choose to treat that loan not as being secured by your home, but as a loan on the new rental property (deduct the loan on Schedule E). Or you can use that money to invest in your business (deduct the loan on Schedule C or on your business tax return). In any case, the money from the loan must go directly to the business account or property purchase escrow or seller. Try to make sure these funds never hit your personal bank account at all. If the funds must get deposited into your bank account first, consider opening a separate account that you only use for that property or business and deposit this money there. Under no circumstances should these funds get mixed in with your personal funds. Otherwise the IRS does something called “tracing.” They trace each check or debit that cleared after the deposit and treat that deposit as being spent on those things (like the dry cleaner, groceries, credit cards, etc.) instead of on your investment. You might want to consider sitting down with a tax professional who is experienced with this area of taxation to work out the details. And consider writing loan documents between yourself and your business or yourself and the rental property to make sure the transaction is kosher. A good real estate attorney can be worth the investment of a consulting fee to ensure you are able to claim these interest deductions in full.

Tip #49:

Often overlooked mortgage interest is the interest on your timeshares. Since most people do not own two homes, they are not subject to all that nonsense we talked about before. But while you may not own an actual vacation home, you probably own a timeshare. Those loans tend to run about ten or twenty years. That is considered a second home. You’re entitled to deduct the interest on it.

Very Special Tip #50:

Uh oh . . . the mortgage is not in your name. We started talking about this in Tip #38. You didn’t have enough credit to get the loan, so your parents are named on the loan and on the title. Technically you are not allowed to deduct the mortgage interest or property taxes since you don’t own the house on paper. You probably get a notice from the IRS each year saying that they don’t have a Form 1098 reporting any mortgage interest in your name, and you have to duke it out with them in the mail, year after year. But this is such a common phenomenon these days that there is a solution. (Tax professionals struggle with this problem. Many don’t know this definitive solution. They know there should be one, but don’t know what the solution is. Now you will know!)

• You are what is called an “Equitable Owner,” or “Beneficial Owner.” When you respond to the IRS, tell them that you are the Beneficial Owner under Treasury Regulation Treas. Reg. § 1.163-1(b) (https://www.law.cornell.edu/cfr/text/26/1.163-1) and the owner on the title will not be taking the deduction. (Feel free to read the regulation.)
• It might not be a bad idea to also get some paperwork drawn up. Have an attorney draw up a contract between you and the owner on the title, spelling out that you are the actual owner and that they just helped you out for credit purposes.
• Have a deed prepared showing the title in your name. Better yet, have your name added to the title with the named owner. (It’s not wise for the person who is responsible for the loan to be removed from title. After all, if you default on the payments, it’s their credit on the line. Without being on title, they won’t be able to get control of the house and they won’t be notified if you default on the loan.)
• If you ever face a tax battle, there’s a really good article about this topic in the Journal of Accountancy based on Tax Court cases that were won (http://www.journalofaccountancy.com/issues/2008/oct/equitableownerequalsdeduction.htm).

Tip #51:

Mortgage interest paid to private lenders. Generally, when you pay a bank or financial institution, they send you a Form 1098 at the end of the year showing how much you paid in interest. It might also include your property taxes, PMI, and insurance payment information. The IRS gets a copy of that and matches it to your tax return. But when you pay a private lender, they don’t generally send you a Form 1098. And most individuals do not think of sending the private lender a Form 1099-INT to tell the IRS how much interest you are paying to that person. Instead, there is line 11 on the Schedule A. That’s where you give the name, address, and Social Security number (SSN) or other Taxpayer Identification Number (TIN) to the IRS. If you don’t have that information, send the lender a Form W-9 to request it (https://www.irs.gov/pub/irs-pdf/fw9.pdf). If you think they will resist providing you with that information, send it certified, with return receipt requested so you can prove that you tried to get it. Then enter all the information you do have with “REFUSED” as the SSN or TIN. Note: You don’t mail the completed W-9 to the IRS. You just keep it in your records for as long as you pay that lender + four years.

Tip #52:

Unpaid interest. Some loans start out with the buyer’s monthly payments being less than the amount of monthly principal and interest. Those are called negatively amortizing loans. While you get a lower payment in the beginning, the unpaid interest gets added to loan balance. Your year-end mortgage statement will show the total amount of interest generate on the loan and the amount that you actually paid. You may only deduct the interest you pay. The unpaid portion will only be deductible when you actually pay it, perhaps several years later.

Tip #53:

Reverse mortgages. A reverse mortgage is a loan where the lender pays you (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home. You don’t have any mortgage payments. What a relief. With a reverse mortgage, you retain title to your home. Depending on the plan, your reverse mortgage becomes due, with interest, when you move, sell your home, reach the end of a preselected loan period, or die. Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan in full.

Tip #54:

Reverse mortgage warning. While you might be relieved not to have to pay a monthly mortgage payment anymore, beware, and read everything carefully. Anything you don’t understand, have them explain, slowly, until you do understand. The interest on the reverse mortgage is generally higher than interest you would normally pay on a regular mortgage. There are a lot of fees they charge that get added to your loan balance. You cannot get any additional cash out of the home if you need it in an emergency. Your reverse mortgage lender controls your equity. If you are married, or have someone you care about (like your child or a friend) living in the home, make sure they are on title before getting the reverse mortgage. Otherwise, if you are forced to move out into a convalescent facility or senior home, they may be kicked out of the house. The lender will demand payment or force the sale of the home when the “owner of record” no longer lives there. So if they are on the title before the loan is issued, they will be protected. But . . . watch out for potential gift and estate tax issues if you add them to title. It would be a good idea to discuss the details about, and alternatives to, reverse mortgages with a tax professional and/or tax attorney.

Tip #55:

Personal residence points. These are the extra fees you typically pay when you get a mortgage. When you buy the home, they are fully deductible. Incidentally, if the points are added to your mortgage and you do not actually pay them, there is no deduction. What if the seller pays your points to help you buy the house? Do you get a deduction? No again. If you don’t spend, you don’t deduct. If you did pay the points, how can you prove that you paid them? Deposit a check for the amount of the points into escrow, or pay it directly to the lender or loan broker. Otherwise . . . there is no deduction at all. Incidentally, if the points are not reported to you on the Form 1098 from your lender, read the instructions to Schedule A and enter those points on line 12 instead of including them on line 10.

Tip #56:

Refinanced points. When you refinance that first mortgage, you must deduct the cost over the life of the mortgage. That is called amortization. If the mortgage is for 30 years, the points are deducted over 360 months. Let’s say you refinanced in the beginning of September. That first year, you will deduct 4/360th of the points (September to December = 4 months). From then on, you will deduct 12/360th until the last year when you deduct whatever is left over.

Tip #57:

Refinanced again points. You have already refinanced once, right? You paid $3,000 and have been able to deduct about $250 so far. But you found a better interest rate (or your credit improved) and you can refinance again. OK, you will amortize the new points as we have described. But what do you do about the old points? You still have $2,750 that hasn’t been deducted, right? Great news! You may deduct that entire balance, since that loan has been paid off.

Tip #58:

Someone else’s points. Sometimes we use incentives to sell our properties. For instance, to close a sale, you offer to pay the buyer’s closing costs, including their points. Is that a deduction to you, as the seller? Nope. That is part of the selling price. You add this to your selling costs and it reduces your overall profit on the sale. So you think this comes out the same in the end? Think again. If the profit on your home is under $250,000 (or $500,000 when you file jointly), you won’t be paying taxes anyway. So this doesn’t matter. And you didn’t get the deduction for the points, since it wasn’t your loan obligation. But at least you finally got to sell the home and stop paying for that mortgage.

Tip #59:

Private mortgage insurance (PMI; https://www.irs.gov/publications/p936/ar02.html#en_US_2014_publink1000296058). This is insurance that you must pay for if your down payment is too low. It’s designed to protect the lenders in case you default. This expense became an allowable deduction sometime around 2007 (https://www.law.cornell.edu/uscode/text/26/163#.Vh_JqivSmSY). However, this is one of those political footballs (like the huge $250 deduction for educators’ costs). Each year, Congress needs to reconsider this deduction and extend it—or not. At the time of this writing, the PMI deduction was good for last year but is not yet approved for this year (2015). Oh Good! Congress extended this through December 31, 2016, as part of the Internal Revenue Code as Section 152 of the PATH Act of 2015. Please see Bonus Tip #270 for more details.

What’s the fuss all about? After all, when your AGI is higher than $100,000 ($50,000 if married filing separately), your deduction phases out. So why can’t Congress make this permanent? Write to your legislators and ask them (http://taxmama.com/special-reports/call-to-action). Meanwhile, before claiming this deduction, please Google the deductibility of PMI each year. That said, just how much is deductible?

• You may deduct the premiums you paid in the current year for the current year. In other words, if you paid a large lump sum in advance that covers several years, you may only deduct the premium for the current year.
• You may only deduct PMI on acquisition debt—that is, loans used to buy, build, or improve a home. You may not deduct it when you refinance.
• For veterans who get loans from the Department of Veterans Affairs, it is commonly known as a funding fee. If it is provided by the Rural Housing Service, it is commonly known as a guarantee fee. Regardless of what it’s called, it follows all the same rules as private mortgage insurance.

Tip #60:

Make your PMI payment go away! As soon as you can, make this financial drain disappear. When your mortgage balance is 80 percent or less than the value of your home, you can make a written request to your lender to cancel the PMI premiums. How can the mortgage balance get that low? A couple of ways:

• Market conditions have improved since you bought the house. If you think they have improved enough, get a formal, written appraisal to prove it. Submit that to your lender.
• You have paid down the principal balance. You can do this by paying a little more than the regular principal payment on your mortgage. For instance, consider adding $50 or $100 per month to your payment. This will bring the principal down slowly. If you can afford a few hundred dollars per month, that will help.
• You have made a lump sum payment on the mortgage to bring it down to below 80 percent of the fair market value of the home. Combine that with the appraisal showing the increase in value and you may be able to save yourself $50 a month or more.

Tip #61:

Avoid PMI altogether. Don’t try to handle your own mortgage application when buying a home. Find a solid, reputable loan broker to help you. Not only can they help you get the best interest rates possible, they can help you avoid paying the PMI in the first place. How? You are only required to pay the PMI if your mortgage loan is for more than 80 percent of the purchase price. A good loan broker can help you get a first mortgage for 80 percent of your purchase price and second mortgage for the rest of the loan. That way you aren’t faced with any PMI costs at all. Naturally, it’s a good idea to pay something down. People who didn’t pay anything down ended up losing their homes when the mortgage industry collapsed. But by getting the first and second mortgages, if you can avoid the extra $50–$100 (or more) premium per month, you can use that money to pay your mortgage loan more quickly.

We have covered a wealth of details about taxes, interest, and insurance and learned a variety of special tips to help you address common problems. Let’s move on to tax credits we can find around the house.