Brillant Deductions
How to make the tax laws work for you
Kevin J. Daum

This article was originally published in the September 2005 edition of Log Homes Illustrated magazine.

What are some of the important dates we remember every year? Birthdays, certainly, and Mother’s Day. Oh, yes, and April 15th, the dreaded income-tax day. It seems that tax questions get more and more complicated each year. Actually the tax laws don’t change that much, but as we get older and accumulate more wealth, our personal tax situations become more complicated.

Owning real estate has a number of tax implications that, properly applied, can save us money and affect the choices we make on how we finance our homes. Let’s take a way some of the confusion and mystery regarding tax deduction and homeownership and examine some basic real-estate tax issues one by one. Of course, all of these issues should be discussed extensively with a tax advisor or Certified Public Accountant in your state, but the information in this article should give you a good foundation for that discussion.

Let’s start with interest deduction. Since the Fifties, home mortgage interest remains the biggest single tax deduction for most people, and for many it can be the primary motivating factor for buying a home in the first place. Mortgage interest is deductible on schedule A of your tax return directly against your ordinary income. There are limits to this deduction, however, and it can be depleted with the wrong types of mortgages. Here are the rules.

Interest on your primary mortgage and secondary mortgages may be deductible on your primary residence and second homes as long as the total combined loan amounts do not exceed $1,000,000 plus $100,000 in credit lines. This means that you could owe $300,000 on your city home and $250,000 on your log vacation home and deduct the total interest paid annually. Construction loan interest also falls into this category.

Don’t get too excited yet; there are some limitations. If you earn more than $146,000 annually, your itemized deductions begin to diminish, although only slightly. In addition, you don’t get to deduct all the interest you take out of the houses from refinancing. Your deductible amount is based upon interest on the lowest balance of the loan, plus any capital improvements, plus $100,000.

Let’s say 10 years ago, you bought a house for $250,000 and borrowed $200,000 originally. Assume you had paid the loan down to $150,000 and had added a room at a cost of $30,000. Now the property has appreciated to $500,000. You decide to refinance, taking a new loan for $400,000.

You would not be able to deduct the interest on the entire $400,000. Instead you would take the $150,000 since it is the lowest amount and add the $30,000 for the improvements. Finally add the $100,000 allowance and your maximum deductibility on this loan would be the interest on $380,000. The only thing you can do to increase your interest deductibility would be more capital improvements or sell the house and buy another. The reduction of $50,000 could cost you as much as $2,500 each year in lost deductions.

These deductibility limitations are some of the main reasons I advocate borrowing the maximum when purchasing and avoiding unnecessary reduction of principal with bi-weekly mortgages or 15-year amortized loans. Considering that in some states combined federal and state tax rates can be more than 40 percent, premature balance reduction can actually cost you tens of thousands of dollars over time.

There is a lesser-known exception to the deductibility limits that applies to those of you with large liquid portfolios that receive investment interest on the schedule B of your tax return. You may be able to take cash out of the house with deductible interest provided that you put the money into an investment. Even then, you can only deduct the interest amount up to the amount of income you claim on your schedule B.

I started with the complicated interest deduction, so let’s rest our brain by looking at a more basic tax principle. All property taxes on any real estate are tax deductible without exception. Regardless of whether the home is a primary residence, second home or rental property, the government is pretty good about not double dipping. If you are paying tax on a local level, Uncle Sam generally gives you the benefit of not paying federal tax on the money you pay to the local governments, including state income tax. The exception to this of course is local sales tax and gasoline tax.

Moving on to points and fees, the most confusing aspect of figuring deductibility on closing costs may be understanding the difference between these two terms. Points are represented as a percentage of the loan amount and therefore considered a form of interest. Other charges, such as for documents, appraisals and attorneys, are fees and are not deductible. Even though points may be called origination or discount fees, if they are represented as a percentage they are deductible, with no limit on the amount, regardless of the size of the loan.

For those of you with loans over $1,100,000 it can actually be tax advantageous for you to pay points to buy down your interest rate. On a $2,000,000 loan, you can deduct the points to reduce the interest that would otherwise not be deductible, saving you thousands of dollars.

The complexity of deducting points relates to when you can take the deduction. If you pay points when purchasing or building a home, you can deduct 100 percent of the points total in the tax year that you pay the points. The timeframe is different for refinances, however. The deduction for points on a refinance must be spread out or amortized equally over the term of the loan. So if you pay $3,000 in points on a 30-year loan, you can deduct $100 each year. That doesn’t seem like a great break. However, when you pay off that loan through a refinance or sale, you can take the remaining deduction in the year of the payoff. So, if you kept the loan and refinance after five years, you would get $100 each year and then $2,500 the year you refinanced.

What about capital gains? The capital-gains tax is a crucial factor when considering the sale of a home. There have been several adjustments in the capital-gains laws as they relate to real estate. The most recent adjustment is a happy one. The maximum tax on capital gains on a federal level was recently reduced to 15 percent. This was a temporary adjustment, but is not likely to be changed in the near future and certainly not in any election year.

The more dynamic change with capital-gains tax occurred in the tax reforms of 1996. The old rules allowed individuals to wipe out $250,000 of capital gains one time only after the age of 52. The alternative when selling a home was to purchase one of equal or greater value and defer the gain. This rule has changed completely. There is still a $250,000 exemption, or $500,000 for married couples, but it is no longer one time and the deferment is no longer an option.

Today, the rules allow you to take the exemption at any age and multiple times. You can only take it once every two years on your primary residence. You must have lived in the property two of the last five years for the property to be eligible. It is not allowed on second homes or rental properties, although if you move into a rental for two years and can document living there, you can then claim the exemption.

Now the only way to defer the gain is by using a 1031 exchange, which is complicated and requires specific actions in short timeframes (Learn more on 1031 at www.orexco.com). But with the ability to take your gain over and over, tax-free deferment should be unnecessary as long as you don’t mind moving every so often.

Many of my clients in high appreciating areas have found this to be a great way of making tax-free money in this hot real-estate market. They will buy a lot and build a home. They live in the new home for two years and start building the new home while living in the first. Every two years they sell and move and pocket the tax-free profit.

There are other complicated issues that vary from state to state and can have great impact on your financial well-being. Some of these relate to estate and survivorship issues and can involve methods of holding title and the use of trusts. It is best to read up on these specifically or, better yet, find trusted advisors that can guide you through their complexities.

As people become wealthier they need to take advantage of all the tax breaks available to them and continue their financial education. Ultimately your tax benefits will be individual based upon your personal income and the state you live in. There is no single approach to examining your tax strategy. However, you can educate yourself and work with a good accountant to figure out which way is best for you. Although I admire the country we live in and the government we have, I can’t think of a single good reason to give them any extra dollars from my wallet that I don’t legally owe it.

About the Author...
Kevin Daum is the Founder and CEO of Stratford Financial Services, a Real Estate finance and education company, founded in 1989. Stratford specializes in Purchase loans, Refinance loans and Custom Home Construction finance and has successfully financed thousands of clients. He is the author of "Building Your Own Home for Dummies" (Wiley), as well as "What the Banks Won’t Tell You." Mr. Daum was an Underwriter for Plaza Savings and Loan and Key Bank of New York. He is an INC 500 CEO and has been listed as one the 40 Most Influential People Under 40 in the San Francisco Bay Area. He is the Global Chair for the Edison Innovation Program with the Young Entrepreneurs' Organization (YEO) and is a founding Board member of the Bay Area Chapter of YEO.

Mr. Daum is a frequent contributor to numerous business publications on the subjects of Real Estate and Small Business leadership and speaks regularly on both subjects. He can be contacted at kevin@stratfordfinancial.com.