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Your TAX QUESTIONS answered

This month we asked Sandy Botkin, the founder of the Tax Reduction Institute and former IRS trainer the most-asked questions from Ask the CPA in the Community Section on the Mortgage Planner University site. The answers are featured below.
Q: If there are two family members on a title, but not the loan of a house, can both receive the tax benefits of the mortgage?

• It depends. If both parties are on the mortgage and this is a principle residence for one of them, they can take a deduction for the interest.
• The catch is that the one taking this deduction has to make the payments for the interest.

Q: Is it true that rental property mortgage interest is only deductible against the income of the property and does not offset ordinary income?

• This is partially true. Real estate losses are deductible against real estate earnings. There are some exceptions, such as if you make under $100,000 adjusted gross a year and somewhat manage your own property and are considered an active investor.
• You can take $25,000 of real estate losses against other income.
• There is a second exception: if the losses exceed your income, then the excess gets suspended. You don’t lose it—it just gets carried over. When you eventually sell that property, all the suspended losses from that company get relieved.

Q: Can you sell an investment condo in California and do a 1031 exchange for a like condo in Maui? Is the 1031 exchange nullified if the financing for this Maui condo is done as a second home?

• You have to transfer investment property for investment property.
• The property you receive has to be rented out.
• You cannot use it as your second home for at least a year.

Q: Are there disadvantages to 529 college plans because they are not always tax exempt when withdrawn?

• There are two types of 529 types.
• The first is a prepaid plan. This covers four years of tuition at a state university. It is all tax free.
• The second is similar to an investment account. It can be used at any college for more than just tuition. All the money you take out is tax free if used for qualified school expenses. Otherwise it is taxable. It can be used for all kinds of family members, including yourself.

Q: What is the deductibility issue of mortgage insurance if your loan exceeds $1.1 million?

• Normally mortgage insurance is deductible for $1 million on the first mortgage and $100,000 for a home equity loan, for a total of $1.1 million. If you buy a $5 million home and take out a $4 million loan, you can still only deduct $1.1 million. For the other $2.9 million, the interest is not deductible. What you use the money for determines whether the interest is deductible.

Steps you can take:

• Liquidate your other investments so that the total debt is $1.1 million on the house. This means the buyer is putting up $2.9 million in cash.
Wait 91 days because any debt incurred within 90 or 91 days of buying a home is considered • acquisition of indebtedess.
On the 92nd day, refinance the home and take out most of your equity. •
Buy back your original investments or any other investments. So, the interest on the first $1.1 • million is still deductible because it is acquisition debt. But now the debt beyond this $1.1 million is considered investment interest, which is deductible against investment earnings.
If you don’t have enough investment earnings, it gets carried over until you do have enough. • The alternative minimum tax will not affect this.
You could also take this equity and put it into a business since business interest is 100-percent • deductible.
Mortgage interest, to be deductible, has to be for the purchase or acquisition or improvement • of your principle residence or second home.

Q: Regarding the tax deduction for a home equity line of credit, does the $100,000 deduction have to be used for home improvement only or is it tax deductible regardless of what you use the money for?

• The interest on that $100,000 beyond the $1 million is deductible regardless of what it is used for.

Q: What are the tax consequences of bankruptcy as opposed to letting your home go into foreclosure?

• You need to see a strong bankruptcy and tax attorney about this.
• With non-bankruptcy, there are basically two tax situations/transactions going on. If the fair market value of the property is worth more than the basis, then you would have a gain.
If the property is worth less than the basis, you would have a loss. •
If the debt is worth more than the property, the difference between the amount left over • on the debt and the property value is taxable income to you. It does not matter if this is rental property or primary home.
There are special considerations given for Katrina relief. •
With bankruptcy, you only pay tax to the extent that you are solvent after the • bankruptcy.
If this is a principal residence, a bill may pass that allows one not to be taxed on the • discharge of indebtedness in the event of a foreclosure.

Q: Is a negative amortization loan deductible in the calendar year it is incurred? How does this work?

• In the IRS code, there is a section about deferred loans or graduated payment mortgages.
• Essentially, in this situation, the person cannot afford their mortgage payment. Therefore, a portion of the payment is added to their mortgage.
• There is no deduction for the buyer on that portion that gets added to the mortgage.

All they can deduct is the payment they are making. They get a deduction when they • start making that portion of the payment.
If the buyer refinances the deferred portion of the loan and defers $40,000, then this • amount is deductible.

Q: Is a negative amortization loan deductible in the calendar year it is incurred? How does this work?

• There are no clear cut answers.
• Points are considered additional interest and are deductible, but if your loan is more than $1.1 million, a portion of these points are not deductible.

Closing thoughts: Keep your eye on this new bill that says:

• The foreclosure of someone’s principal residence or a short sale will not result in taxing them.
• There will be changes. For instance, if you own a second home, you can avoid taxes by moving into it for two years and then selling it.
• You will have to pay some tax if you used it as a rental or vacation home in the past five years starting in 2008.

Sandy Botkin is a CPA, attorney and principal lecturer at the Tax Reduction Institute. He is a former trainer of IRS attorneys and the author of “Lower Your Taxes: BIG TIME” and “Real Estate Tax Secrets of the Rich.”