Expert advice: Tax breaks on your house

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A few weeks ago, I offered you the opportunity to ask David Bergstein, professional tax analyst and CPA, your tax questions and a chance to get a free account at CCH CompleteTax.

Some of this is pretty technical, but I wanted to get your advanced questions answered, so here are David’s answers.

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“IWTYBR readers posted some excellent questions. One of the main categories appears to be related to homes. So, I’d like to tackle that area. Before I do, let me just caution you that these are general comments not specific tax advice. For tax advice about your specific situation, you should seek the one-on-one guidance of a CPA.

Advanced tax breaks for home owners

Home ownership is both a blessing and a curse. The blessing is you have a place to live and hopefully, over time, you will build equity. As I read the questions, there seems to be a lot of interest in what happens when you sell your home. So I will give Ryan, ZT, Chris, Steve and everyone else information to start with that can be followed up with a visit to a CPA or a site such as www.completetax.com where you can access the free Tax Guide for additional detail and examples that will help you.

Starting with the basics: Generally, a taxpayer may exclude from gross income up to $250,000 (or $500,000 for qualified spouses filing jointly) of gain on the sale or exchange of a principal residence. The taxpayer must have owned and used the home as a principal residence for an aggregate of at least two of the five previous years. The exclusion applies to only one sale or exchange every two years. In the simplest of terms, an exchange is basically a swap of properties.

Ownership and Use Test. The required two years of ownership and use need not be continuous. The test is met if the taxpayer owned and used the property as a principal residence for a total of 730 days (365 x 2) during the five-year period before the sale. The ownership and use test may be met at different times (i.e., ownership of previously rented home), provided that both tests are met during the five-year period before the date of sale. Short temporary absences for vacations or seasonal absences are counted as periods of use, even if the taxpayer rents out the property during those periods.

The home that is sold does not have to be the principal residence at the time of the purchase or sale. For example, taxpayers could move into their vacation home, convert it into their new principal residence and have up to three more years to sell their old principal residence to take advantage of the exclusion. The residence also doesn’t have to be a traditional house. It can be a condominium, houseboat, house trailer or stock held by a tenant-shareholder in a cooperative housing corporation.

Amount of Excludable Gain. The entire gain on the sale of a principal residence may be excluded up to $500,000 for married individuals filing jointly if:

(1) either spouse meets the ownership test,

(2) both spouses meet the use test, and

(3) neither spouse is eligible for exclusion by virtue of a sale or exchange of a residence within the last two years.

If the spouses do not meet all three requirements, the exclusion is determined on an individual basis and equals the sum of the exclusion limitations to which each spouse would have been entitled had they not been married.

With this basic background, let’s look at a few of the questions readers asked.

Ryan wanted to know if he qualified for a prorated exclusion. The exclusion is prorated if a taxpayer does not meet the two-year ownership and use requirements in the case of a sale or exchange due to a change in place of employment, health or unforeseen circumstances. In such cases, the amount of the available exclusion is equal to the amount of the applicable exclusion ($250,000 or $500,000) multiplied by the ratio of:

(1) the shorter of

(a) the aggregate periods during which the ownership and use requirements were met during the five-year period ending on the date of sale; or

(b) the period after the date of the most recent sale or exchange to which the exclusion applied, over.

(2) two years.

The five-year period may be suspended during any period that the taxpayer is a member of the uniformed services or Foreign Service on official extended duty. A sale will be considered as occurring primarily because of unforeseen circumstances if any of the following events occur during the taxpayer’s period of ownership and use of a residence:

(1) death;

(2) divorce or separation;

(3) becoming eligible for unemployment compensation;

(4) a change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses;

(5) multiple births resulting from the same pregnancy;

(6) damage to the residence resulting from a natural or man-made disaster, or act of war or terrorism; or

(7) condemnation, seizure, or other involuntary conversion of the property.

From Ryan’s post, it appears he sold his home to study abroad. That is not one of the IRS-defined reasons for allowing a prorated exclusion. However, if additional circumstances (as outlined above) apply to his situation, he may be able to take a prorated exclusion.

Steve questioned whether he had to pay taxes on the sale of his home in one year even though he then used that money to purchase a new home the following year. Generally speaking, your tax obligation related to the sale of your home has nothing to do with whether or not you purchase a new home with the proceeds. The tax obligation on the home you sold is related to whether or not the profit you realized exceeded the $250,000/$500,000 exclusion. If not, then no capital gains are owed on the proceeds; if gains were more than this, then taxes are owed on that amount.

ZT also had a question on selling a home. Several costs related to closing are deductible. These include the interest and real estate taxes that are allocated to the seller; and for the buyer, the points, interest, real estate taxes and costs for private mortgage insurance. When you sell a house you add the expenses of fixing it up to the basis to reduce you gain. Sales commissions reduce your amount realized and thus your gain also.

Chris wonders if he should be able to take some of the home-related deductions for a home jointly owned with someone else. Generally speaking, you are entitled to deduct interest and taxes on residential property that you own as either your primary or secondary home. If this is the case and the home is jointly owned with one person having taken all the deductions, then both parties would need to file amended returns for the specific tax years if they now decide that the deductions should have been shared. Rules are different if the property is investment property, if it’s rented out, etc. In instances like this, where there are multiple parties and extenuating circumstances, consulting a tax professional is strongly advised.

Darkling, Kode and Elizabeth all have questions related to the first-time homebuyer tax breaks. I wrote about these in my previous column.

Let’s start with Kode’s question about the timing of taking the first-time homebuyer credit. If you purchased a home in 2009 and already filed your 2008 tax return without taking the credit, you can file an amended return to claim the credit on your 2008 tax return. But you do have to have purchased the home before July 1, 2009, to take the credit on your 2008 return. You do use the form F5405. There is confusion because the initial F5405 for 2008 only included the $7,500 credit, which also was to apply to homes purchased in 2009. Earlier this year, however, legislation changed the rules for first-time homebuyers who purchased their home in 2009, increasing the credit to $8,000. This required the IRS to create a new F5405 for 2008. So, another group of people that may want to file an amended return are those that purchased a home in 2009 and are eligible for the $8,000 credit but used the old F5405, taking only the $7,500 credit. The IRS may issue specific instructions here on whether they will automatically do this but there is nothing at this point in time

Darkling bought a home in 2008 and asked whether he could take the more generous $8,000 tax break for 2009 or was stuck with the $7,500 tax credit offered to first-time homebuyer in 2008 that needs to be paid back. Timing is everything. As of this point, the new rules for 2009 are not retroactive. So, if you purchased your first home in October 2008, then the $7,500 credit that must be repaid applies, assuming you meet the other criteria for this credit.

Finally, Elizabeth asked whether there are downsides to taking the first-time homebuyer credit on the 2008 tax return if you bought the home in March 2009. If you take the credit on your 2008 tax return, you will lower your tax bill immediately, and you will still be able to take the home-related deductions in 2009.

These were all great questions. The above should provide you a general starting point at the least. As always it’s a good idea to follow up with a CPA if you have complicated tax issues or use a site like www.completetax.com to help you with preparing your taxes.

About the Author: David Bergstein, CPA, is a tax analyst for CCH CompleteTax.

Winners: As promised, we’ve chosen the 10 best questions we received and are giving them each a free accout with CCH CompleteTax. The 10 winners are:

Uriel, Laura, Chris, Henry, Karen, Andrew, Deb, Candice, Satya, Amanda

Congratulations to our winners! We will be contacting you within 24 hours with your free codes.

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6 Comments

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  1. I own a two-bedroom condo and rent out one room to a tenant/roommate. Can I still deduct mortgage interest and property tax? What about the condo fee and home improvements that are generally deductible for rental properties, as well as depreciation?

  2. Thanks for the answer. Really appreciate it and thanks Ramit for setting this up.

  3. David
    I think your answer to Kode’s question is not totally correct.
    For homes purchased in 2009, you can elect to claim tax deduction on either 2008 return or 2009 tax return. You do not need to buy the house before July 1st,2009 to do that. You can elect to claim your deduction on 2008 if you buy the house between Jan 1st 09 and Dec 1st 09. . Please check your answer again.

  4. David Bergstein Link to this comment

    John, thank you for your careful reading. The first-time homebuyer credit for a home purchased in 2009 can be taken on either the 2008 or 2009 tax return. For homes purchased in 2009, the requirement for claiming the credit on a 2008 tax return is that the home is purchased after December 31, 2008 and before December 1, 2009.

  5. Adele Peterson Link to this comment

    I was hoping you could clarify something for me. My children have irrevocable trusts (created in Oklahoma for rental income) that their grandfather set up for them. They have K-1′s they get each year which go on their EIN numbers. The trust is set up so they each get 1/3 when they are 25, 2/3 when they are 30, and the remainder when they turn 35. Each trust earns around $5800 a year and the money that is distributed is put in a trust bank account. My children are 17, 14, 12, and 8. I discovered last year that I am most likely filing incorrectly every year that the children have been alive. My accountant has filed every year on a 1040 using their SS numbers. Instead, they should be filing on a 1041 with the trusts EIN number. It is my understanding that they should have been paying a trust rate of 28% for all these years instead of their parents 33% and higher rate. They also pay state tax in Oklahoma and Minnesota for the trust income. All of this income is earned in Oklahoma.
    Can I only go back to 2005 to amend and will I be penalized for not filing on the correct form even though I have overpaid on the 1040? Also, does the trust pay Oklahoma and Minnesota or just Minnesota?

  6. My comment for Adele is to stop in and see a CPA. The facts here might need to be explored a little more to see if you are required to file in two states or not. One can always file an amended return and claim a refund if they are entitled to it. Form 1040X (amended return)must be filed within 3 years from the date of your original return or within 2 years from the date you paid the tax, whichever is later. Returns filed before the due date (without regard to extensions) are considered filed on the due date.