Knowing the Tax Benefits Of Financing Your Home

Home mortgage refinancings were as popular in 2002 as the TV show American Idol. But American Idol star Kelly Clarkson has since done a disappearing act. Your mortgage payment keeps showing up every month.

Home financing does have its tax benefits, though, especially if you refinanced for a low rate or bought or sold a home in 2002. Here's what you need to know.

How Low Can You Go?

With interest rates as low as 4% on some loans, 2002 was the year of the refinanced mortgage. Many people refinanced more than once.

For the most part, the tax reporting process is pretty straightforward. But if you paid points on a refinanced loan, pay attention.

Points are charges paid by a borrower to secure a lower rate. Each point costs about 1% of the loan. Sometimes called “loan origination fees,” “maximum loan charges” or “premium charges,” points are out-of-pocket charges and you can deduct them.

The issue is when. In most instances, points from a refinancing are deductible over the life of the loan, says Mark Luscombe, principal federal tax analyst with CCH, an Illinois-based provider of tax information to professionals. So if you refinanced in 2002 and paid $1,000 in points on a 10-year loan, you could deduct $100 each year starting this April.

The deduction schedule is more advantageous on original mortgage loans. Those points are fully deductible in the year you get the loan.

If you got caught up in the frenzy and refinanced a refinanced loan (like yours truly), then the portion of the points that had not been deducted from the first refinance are fully deductible now, says Martin Nissenbaum, national director of personal-income-tax planning at Ernst & Young. Any points you pay on the new refinancing must be deducted over the life of the loan again.

There's a groovy little exception to that rule, though.

The IRS put out a statement at the end of 2002 stating that if you refinanced and took extra money out to do work on your home, you can deduct a portion of the points you paid that are attributable to your home improvements, says Mr. Nissenbaum.

We need an example. Say your mortgage was $70,000 and you decided to refinance that amount in 2002 to lock in a lower interest rate. This time, though, you took $100,000 to build your dream kitchen. You paid $1,000 in points on that new loan. Since $30,000, or 30% of your loan, is going toward home improvements, you can deduct 30%, or $300, of the points you paid, on your 2002 tax return. The remaining points will be deducted over the life of the loan.

Where do you report all these points? On line 10 of your Schedule A – Itemized Deductions, along with your deductible mortgage interest, which we'll tackle next.

Tally that Interest

As long the amount of your mortgage (original or refinanced) is $1,000,000 or less, any interest you pay on that loan is fully deductible, as long as your house secures the loan and you use the house as your principal or secondary residence.

If, instead, you decided to take out a home equity loan to build that dream kitchen, which just about everyone I know (except yours truly) did last year, your interest is deductible on a loan of up to $1,000,000 as long as the proceeds of that loan are used to acquire, construct or improve your home.

If you took a home equity loan to pay for junior's college education and buy that 1972 Corvette you've had your eye on, the interest on that loan is only deductible on the first $100,000 of the loan's principal, says Rande Spiegelman, VP of Financial Planning at the Charles Schwab Center for Investment Research.

Interest paid on mortgages and home equity loans is reported on Form 1098. But if you refinanced, you'll receive two Form 1098s this year (or more if you refinanced more than once in 2002), even if you refinanced with the same bank. So be sure to pick up both numbers when reporting your mortgage interest on line 10, Schedule A.

If you borrowed money from someone other than a bank, e.g. your seller financed the deal, those lenders may not be required to send you a 1098. While you are still eligible to deduct any qualified interest, you'll need to explain the situation to the IRS on your tax return, notes Mr. Nissenbaum. That unreported interest goes on Schedule A, line 11 and requires the name, address and ID of the person who made you the loan.

Trading Places

Even though the prices of homes were, uh, through the roof, people still bought and sold plenty last year. Sales create lots of tax fun.

Let's say you sold your home in 2002. If, during the preceding five-year period, you owned that home for at least two years and lived in it as your main home for at least two years, you will not owe tax on up to $250,000 of gain from the sale as a single person and up to $500,000 as a married couple.

So if you bought your home for $300,000 and sold if for $500,000, the $200,000 is tax-free money to you as long as you meet the above rules.

That's good stuff.

Be careful when calculating your actual gain, though. While it may seem that you just subtract the price you paid for the home from the sale price, there are other factors.

To start, improvements you made to your house over the years add to your original cost, so factor in that new roof and extra bedroom.

Then be sure to subtract from your gain all the ancillary costs you incurred to sell the place. Those include advertising, legal fees and sales commissions. So if you grossed $200,000 on the sale of your house but spent $30,000 to do it, you really only have $170,000 in your pocket.

On the buyer's side, while none of those annoying out-of-pocket fees are deductible, they should be added on to the cost of the property you're buying. So keep track of things like legal fees, settlement and closing costs, title insurance, surveys, and transfer taxes.

On a More Morbid Note

If you die and leave your home to someone, that person will inherit your home at its fair market value, reminds Mr. Luscombe. The technical folks say the beneficiaries received a “step-up in basis.” That means if you bought your home in 1950 for $20,000 and it's worth $500,000 today, the lucky person inheriting your home after you're gone will never pay tax on that $480,000 gain. This perk is set to expire in 2010 when the estate tax disappears, so if you're going to die, do it within the next few years.

Hey, you do what you can to beat out Uncle Sam.

Be sure to check out IRS' Publication 523 -- Selling Your Home and Publication 530 -- Tax Information for First-Time Homeowners, for more details.

Write to Tracy Byrnes at Tracy_Byrnes@yahoo.com