MORTGAGE INTEREST RULES CLARIFIED!
The 1997 Taxpayer Relief Act permits taxpayers to retain, tax free, up to
$500,000 (for married couples) in capital gain upon the sale of a personal
residence. Single taxpayers may obtain up to $250,000.
To qualify for the exemption, the taxpayer must have occupied the home for
at least two of the previous five years prior to sale. The IRS has clarified
that the act also provides taxpayers who live in the property for less than two
years the right to shield a portion of their gain from taxation. To qualify,
the sale of the property must have been because of a change in employment,
health reasons or other "unforeseen circumstances".
The law provides that this "proportional" benefit means that if a
taxpayer lives in the property for one year instead of two (and meets one of
the above reasons for sale), a single taxpayer may pay no tax on up to $125,000
worth of gain ($250,000 if married) as opposed to having to pay one-half of the
tax that would otherwise be owed.
The original law further indicated that the test for "unforeseen
circumstances" would not be enforced until August 1999. The primary reason
for the delay was that there was no consent on what the phrase actually meant.
While we are long past this date, there is still no agreement on what
constitutes "unforeseen circumstances".
When the 1997 regulations were published, the "two out of the last five
year" rule made for some interesting scenarios under which sellers might
escape paying taxes. Note that the seller does not have to be living in the
home at the time of the sale, but merely must have lived in the home two of the
last five years. One of the other aspects of this new law was the ability for
investors to move into and occupy a rental property (thereby converting it into
a personal residence) for two years and then sell it and benefit from the up to
$500,000 exemption. Remember, the rule is that one can take advantage of this
benefit every two years.
When the IRS realized that investors were taking advantage of the ability to
convert rentals into personal residences and escape capital gain taxation, a
new rule was adopted. For residences acquired in a 1031 tax deferred exchange,
the property must now be held a minimum of 60 months (five years) to qualify
for the exemptions. Other principal residence sales retained the minimum 24
month holding period, presuming that the owner occupied the principal residence
during that period.
More recently, the IRS closed yet another loophole. The two year holding
period was being used more frequently by rental property owners wherein they
would move into the rental for two years, converting the home to personal
residential property and then taking advantage of the capital gains provision.
The new rule requires that if the new tenancy (in an already owned rental
property) is at least two years but less than five years, the capital gains tax
will be proportionately distributed between the occupancy and rental periods.
In other words, some capital gains will be paid in those situations where
tenancy is less than five years.
Another clarification from the IRS involves the interest deduction regarding
those loans that over encumber a property. The IRS indicated that the interest
on loan amounts that exceed the value of the home is not eligible for a tax
deduction. In other words, the equity interest deduction is limited to interest
on loan amounts up to but not greater than the market value of the home less
current acquisition indebtedness. $100,000 is the maximum limit, under all
circumstances, for the equity loan interest deduction benefit. In order to
enforce this rule, the IRS prepared a revised 1098 form to be sent annually to
all mortgage lenders and home loan borrowers, with a mandatory copy to the IRS.
This is one of the reasons we have seen a reduction in the promotion of these types
of loans and that most ads now suggest (in the fine print) that a borrower
should consult a tax advisor if over-encumbering their property.
In fact, consulting a tax advisor, is good advice
under most circumstances, and we highly recommend it. It is always a good idea
to determine your tax consequences when contemplating any real estate
transaction.
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