Preparing For April 15 – The IRS Limits The Interest Deduction On Non-Married Couples

Preparing For April 15 – The IRS Limits The Interest Deduction On Non-Married Couples

As the tax filing deadline for the 2011 tax year nears, the IRS has recently ruled on a subject that will be of interest to many taxpayers who co-own property with a person who is not their spouse.

First, let’s review the basic rules on home mortgage interest deduction. Taxpayers who itemize deductions on Schedule A can include interest paid on mortgages with certain limits. Only interest paid on a loan secured by a principal residence, and a second home, is deductible. Additionally, taxpayers can only deduct interest on loans for which they are legally liable. So contributing to the payments on a loan for someone else will not qualify.

Assuming these criteria are met, the amount of interest a taxpayer can claim is limited. Taxpayers cannot deduct the interest on more than $1,000,000 of debt for their first and second residence together. Married couples filing jointly are limited to $1,000,000 for the couple, and if they file separately the limit is reduced to $500,000 each. In addition, a taxpayer can also deduct the interest on the first $100,000 of home equity loan debt. So an unmarried taxpayer with a mortgage and home equity line of credit could deduct the interest on $1,100,000 in total.

But what if an unmarried couple jointly owns a home together that has more than $1.1 million of qualifying mortgage debt? Can each taxpayer deduct the full extent of their individual limit? Prior consensus had always been yes. But recently, the IRS ruled that the limit should be applied applied by residence, not by taxpayer. Thus, one or two homes which are the principal and second homes cannot provide more than a total of $1.1 million interest credit no matter how many taxpayers own the homes. Once the $1.1 million of interest deduction is used from the first and second home, no further interest deduction can be claimed.

An example will help. Suppose Bob and Sue own two homes jointly and are not married. The principal residence has a first mortgage debt of $1,500,000, and the second home has a first mortgage debt of $1,000,000. There is no home equity loan in place on either. According to this ruling, Bob and Sue cannot together claim interest on more than $1,000,000 of total mortgage debt, despite the fact that they file separately and are not married, because the mortgage debt is related to the same first and second homes. If instead, Bob owned property one with debt of $1,500,000, and Sue owned property two with debit of $1,000,000, then each taxpayer could claim the full $1,000,000 limit providing they were otherwise eligible.

Tax planning can help in this situation. Non-married couples who own a first and second home should consider structuring transactions to have one home owned entirely by the first taxpayer and a second home owned entirely by the second if this is possible. Under that scenario each taxpayer should be able to deduct the full extent of the interest on $1,000,000, rather than splitting it as they would when owning both homes jointly. Non-married co-ownership is common in our market and likely on the increase, so be careful to consult tax advisers before purchasing to ensure that the structure permits maximum deduction.

Exchange Basics - The Rules For Identifying Replacement Properties

Exchange Basics: The Rules For Identifying Replacement Properties

A 1031 Exchange is a great way for investor’s to develop significant wealth by deferring capital gains tax on the sale of assets that are replaced with like-kind properties. But this generous benefit of the Internal Revenue Code comes with a caveat: Read more

Buying A Short Sale. Some Rules Of The Road

Buying A Short Sale? Some Rules Of The Road

Sellers who owe more on their home than it is worth often choose to try a short sale, which requires approval from the bank to sell for less than what is owed. These deals can be good for both the buyer and seller, but before entering into one, there are some important considerations a buyer should ask.

What is your time frame? While the approval process is shorter than it has been in the past, buyers on strict timetables should think twice before signing a contract to purchase a short sale. These deals can take 60-90 days on average to approve, and sometimes more. Buyers needs to be aware of this and plan accordingly.

Be sure there is an escape hatch: These deals require third-party approval (e.g. the seller’s payoff bank) so the contract must have a provision making the deal contingent on receiving this. But don’t leave it open-ended. Typically the contract provides for a 90 day window to get the approval, after which the buyer can terminate the contract and receive a refund of the contract downpayment. Without this important provision a buyer could be stuck in limbo indefinitely while the payoff bank deliberates over the deal!

Transaction costs are not refundable: Buyer costs like inspection, appraisal, survey, title search and legal fees are not refundable in the event the deal does not close. But in a typical non-short sale transaction, buyers are willing to expend the resources since the seller is bound to sell once the buyer’s financing bank is ready to go. But in a short-sale, even a willing seller cannot force the payoff bank to approve the deal. So there is a risk for buyers who expend fees in preparation for a deal, only to have a short sale bank reject the deal. Since this is the case, careful buyers must remember two points here: (i) there should be a price concession in exchange for this, and (ii) the short sale deal must be within the realm of reason. Short-sales are arms length transactions valued at market, but it is typical to have some price concession in exchange for the additional risk that a buyer incurs with non-refundable expenses and the increased timeline to close. But the “short-sale discount” cannot be so large that the bank will not approve the deal. The seller’s payoff bank will either engage their own appraiser or use a broker’s price opinion to ensure that the price reflects something close to fair market. Be sure the contract contains a provision that permits the buyer to unilaterally increase the purchase price in the contract if the payoff bank comes back with a counter-offer. Without that, the seller would have to consent to a change in price. While most sellers in that case will, the right to increase the price should be the right of the purchaser in the contract without having to get seller consent.

Is the seller really in financial hardship? Banks will only approve short-sales with a financial hardship. Simply owing more on the house than it’s worth will not be enough. Careful buyers should inquire on the nature of the hardship, and include representations in the contract supporting this.