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LeAnn Luna

Five New Favorable Developments in Housing Taxation

Why tax preparers need to be aware of new legislation affecting homeowners.

September 11, 2008
by LeAnn Luna

The mortgage and housing crisis is daily news, with record numbers of homeowners either in foreclosure or behind on their mortgage payments. In response, Congress recently passed two homeowner-friendly bills: the Mortgage Forgiveness Debt Relief Act of 2007 and the Housing and Economic Recovery Act of 2008.

The Mortgage Forgiveness Debt Relief Act of 2007 included the following three new tax breaks for homeowners:

  1. Provides tax relief for cancellation of indebtedness income relating to a primary residence,
  2. Extends the temporary deduction for mortgage insurance and
  3. Extends the period that a widow or widower could sell a primary residence and still claim the full $500,000 profit exclusion.

The Housing and Economic Recovery Act of 2008 included these tax provisions:

  • Allows non-itemizers to deduct a portion of their property taxes
  • Creates a $7,500 refundable “credit” for first-time homebuyers

Debt Forgiveness Not Included in Income

The almost unprecedented scope of home price declines leaves many new homeowners “upside down” — owing more on their mortgages than the underlying property is worth. Lenders are foreclosing on some properties, renegotiating loan terms and in some cases reducing principal balances owed. Prior to the Mortgage Relief Act, the forgiveness of debt in either case could result in a nasty surprise to homeowners. Forgiven debt either through renegotiation or foreclosure could be considered cancellation of indebtedness income and be subject to income tax. However, the new rules temporarily allow such debt relief to be excludable from income up to $2 million in debt forgiveness.

Two important limitations apply. First, the relief is only available for loans secured by the taxpayer's principal residence. Mortgages related to second homes and/or rental properties do not qualify for this favorable treatment. Second, the debt must be related to the purchase or substantial improvement of the personal residence. First mortgages qualify, whether it was the original mortgages or a refinancing that did not at the time of refinancing exceed the original loan's value. Home equity loans may also qualify if the proceeds were used to substantially improve the primary residence. However, home equity loans used for other purposes, such as loan consolidation, medical care, tuition, etc. do not qualify. The IRS requires taxpayers to document qualified home improvement expenditures.

Taxpayers who default on loans used for disqualified purposes may still avoid income taxes on debt forgiveness. Under long-standing rules, taxpayers who file for bankruptcy under Title 11 or are insolvent both before and after the default or debt renegotiation will generally not be required to include the debt forgiveness in income.

Extension of the Deduction for Mortgage Insurance

Most borrowers who make less than a 20 percent down payment on their home purchase are required to buy mortgage insurance either through private companies or a variety of government agencies. Under the new rules, taxpayers with adjusted gross income (AGI) less than $100,000 are entitled to deduct those mortgage insurance payments. The deduction is fully phased out for taxpayers earning more than $109,000. The deductions apply only to loans originating after December 31, 2006 and before January 1, 2011.

Extension for Surviving Spouses

Married taxpayers can exclude up to $500,000 of gain on the sale of their principal residence while single taxpayers are only allowed to exclude up to $250,000. Widows and widowers could take advantage of the full $500,000 exclusion only if the house was sold in the tax year of their spouse's death, without regard to when that death occurred. For example, if the death occurred on December 15, the surviving spouse had only until December 31 to make the sale. The new rules give the surviving spouse two years from the date of death to qualify for the full $500,000 exclusion.

Property Tax Deduction for Non-Itemizers

For 2008 only, taxpayers who do not itemize can still deduct a portion of their property taxes. The deduction is limited to the lesser of the taxes paid or $500 for single taxpayers and heads of households and $1,000 for married taxpayers filing a joint return. The new rules will be most advantageous to those who have paid off or nearly paid off their mortgages and whose other itemized deductions do not exceed the standard deduction. Lower income taxpayers using the standard deduction may also get an additional benefit from their property taxes for the first time. Tax return preparers should recognize that all homeowners are eligible for a property tax deduction in 2008.

Refundable Credit for First-Time Homebuyers

An unusual item in the 2008 Housing bill is a tax “credit” for first-time homebuyers. Eligible taxpayers are first-time homebuyers or those who have not owned a home used as a primary residence for at least three years. Owning a rental or vacation home does not count against the taxpayer for this test. There are income limits. For single taxpayers, the phase-out begins at an AGI of $75,000 and is fully phased out at $95,000.

For married taxpayers filing a joint return, the phase-out range is between $150,000 and $170,000. For qualified home purchases that close between April 9, 2008 and June 30, 2009, the purchaser can take a refundable credit equal to the lesser of $7,500 or 10 percent of the purchase price of the home. However, the tax credit is not really a credit but rather a tax-free loan.

Beginning in 2010, taxpayers will have to begin repaying the credit at a rate of $500 per year until the credit is fully repaid or up to 15 years for those who took the maximum credit. If the home is sold before the credit is fully repaid, profits on the sale go first toward repaying the credit. However, homeowners who sell at a loss or whose gain does not exceed the remaining unpaid credit will have the credit forgiven. This provision effectively acts as a $7,500 insurance policy against further home price declines, with the face amount declining by $500 per year.

Conclusion

As tax practitioners, updating your knowledge on these new provisions will help you better advise your clients and save them money. Keeping your clients happy means more business and more referrals. What more would you want?

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LeAnn Luna is an associate professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.