E-NEWSLETTER
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Life is full of milestones. It’s those significant events that we all go through at some point in our lives, like getting married, having a child, buying a home, a divorce, the death of a loved one, etc. Most of these events will affect not only our emotions and finances, but will also have significant tax implications that are often overlooked at the time of the event. This section is devoted to providing tax information related to a variety of life events. It will be a useful guide that covers everything you need to know about the specific event that you are experiencing. It tells you what to expect, things to avoid, the possible consequences of making such a move, and different scenarios that may apply to the situation.
We hope that the information provided in this section will help you cope with any life event that comes your way and encourages you to seek professional assistance when necessary.
When a taxpayer becomes married, his or her tax filing status will change. This change in filing status can have significant implications on tax liability, both for the good and bad. A taxpayer’s filing status for the year is determined on the last day of the tax year. Therefore, even if a taxpayer is single for the majority of the year but gets married before the close of the year, he or she must file as a married individual for the entire year. It is not uncommon for tax professionals to recommend waiting until after the close of a tax year to get married. Once a taxpayer is married, he or she must choose between one of the following options: . • File a joint return where the couple’s incomes and deductions are combined and all the tax limitations and benefits apply to them jointly, or • File as married individuals filing separately, which may or may not provide any tax benefit. This may cause a larger combined tax than filing a joint tax return, since the tax code includes penalties to prevent married taxpayers from gaining any tax advantage by filing separately. There is no magic wand to determine what the impact will be on an individual’s tax liability once he or she gets married. It is complicated because the tax code includes a vast number of adjustments that must be made to the tax return based upon the taxpayer’s marital status, income, deductions, exemptions, credits, etc. The only thing that can be done is to make a careful evaluation of all the issues that are unique to each of the individuals entering into the marriage. Although the tax code is riddled with factors that are related to marriage, the principal ones are summarized below:
• Tax Rates
• Deductions
• Exemption
• Phase-Out IRA Limits
• Social Security Taxation
• Home Sale Issues
• Allocation of Tax Due & Refunds
• Passive Loss Limits
• Education Credits
• Child Care Credits
• Home Mortgage Interest
• Beneficiaries, Title to Property and Wills
• Capital Gains & CG Rates
• Taxation on Dependent Children
Tax Rates – Each filing status has a different tax rate schedule based upon taxable income. As the taxable income increases, so do the tax rates for that marital status. This can create some unexpected results, especially when both taxpayers have income. For example, let’s consider a couple where only one has taxable income; prior to marrying, the filer uses the single status and rates, but once they are wed, lower joint tax rates will be used for the same income and a lower overall tax can be anticipated. On the other hand, if both have income, that income must be combined to determine the couple’s joint tax rate; this can throw them into a higher tax bracket, resulting in a larger tax bite than if they been able to file as single individuals. In addition, the tax rates are determined from taxable income which can be affected by a variety of other factors listed below.
Deductions – Both single and married individuals can choose to use the standard deduction or itemize their deductions. However, once they are married, this option is only available to the couple jointly. Prior to marriage, both could claim the standard deduction or one could claim the standard allowance and the other could itemize, but while married they must choose one or the other. The result can be a significant loss of deductions for the year. This, in turn, can lead to a higher taxable income and thus increased tax. A married couple cannot get around this problem by filing married separate returns, since the tax code requires both to itemize their deductions if either of the couple itemizes.
Some itemized deductions are required to be reduced by a percentage of adjusted gross income. For example, only medical expenses in excess of 7.5% of AGI are deductible. Also, there is an overall itemized deduction limitation based on AGI that applies to higher-income taxpayers. Because the joint return of a married couple combines their incomes, the allowed deductions may end up being less than if the couple could file as unmarried individuals. Take for example an individual with AGI of $40,000 and $5,000 of medical expenses. If unmarried, she would include $2,000 of the medical expenses as part of her itemized deduction total ($5,000 - ($40,000 x 7.5%)). If this individual married during the year and her spouse also had income of $40,000 but no medical expenses, they would not be able to deduct any of her medical costs because 7.5% of their combined $80,000 AGI is $6,000, which exceeds the $5,000 of expenses.
Exemption Phase-Out – Each individual filer and each dependent included on a tax return provides the filer with an exemption allowance (deduction) for the tax year. However, through 2009, the exemption allowances partially phases out for higher-income taxpayers. Thus, when marrying and combining incomes, there is a chance that the exemption amounts may be partially phased out, resulting in increased tax for the year.
IRA Limits – A contribution to a Traditional IRA may not be tax deductible, if the taxpayer or his or her spouse has a retirement plan where they work and their income exceeds a certain amount. Contributions to Roth IRAs may be prohibited altogether depending on income level. Because of these factors, newly married individuals may find that they are no longer eligible to take a deduction for a contribution to a Traditional IRA or contribute to a Roth IRA. This can be especially troublesome for a taxpayer who already made a contribution for the year, based upon their individual income and unmarried status, and then subsequently marries in the same year.
Social Security Benefits Taxation – For lower-income individuals, Social Security (SS) income may be tax-free. However, as a taxpayer’s income increases, the SS income becomes taxable. The threshold for the taxability of the SS income is $25,000 for single individuals and $32,000 for married individuals filing jointly. Combining the incomes of individuals who were previously filing as unmarried and now file jointly generally causes more of the SS income to be taxable. Married individuals who lived together at any time during the year and who file using the married separate status have a zero threshold before their SS income becomes taxable, so there is a major disadvantage to filing separate returns for SS recipients.
Home Sale Issues – A taxpayer who sells his or her main residence after owning and using it as their primary residence for two out of five years prior to the sale qualifies for a $250,000 gain exclusion. Even if the two-out-of-five rule isn’t met, the taxpayer could qualify for a partial gain exclusion. When a couple files a return and they both meet the two-out-of-five-years use requirement, they each qualify for a $250,000 exclusion, thus doubling the excludable amount to $500,000. Where only one spouse owned a home prior to the marriage and would only qualify for a $250,000 exclusion, the couple would qualify for a $500,000 exclusion after marriage once the spouse without a home meets the two-year use requirement.
Where both spouses owned a home before getting married, they can sell either or both of the homes and each benefit from a $250,000 exclusion. There are a number of complications that can be encountered with the complex home sale laws, so be sure to consult with this office prior to taking any home sale actions.
Allocation of Tax Due & Refunds – Married individuals combine their income, deductions, credits, etc., when filing jointly. If there is a refund, it is issued as a single check. Couples who maintain separate funds and accounting will have to determine how to allocate the refund between them. On the other hand, if there is a tax due, the government treats that tax due as a joint liability. If it is not paid, the couple will be pursued both jointly and individually for tax liability.
Where an individual has a tax liability prior to marriage and then files jointly after marriage, the refund from the jointly-filed return can be withheld to pay the spouse’s prior tax liability.
Passive Loss Limits – Where taxpayers have passive losses, most typically from operating rental property, only $25,000 of the losses can be deducted each year (after offsetting any passive income). In addition, the $25,000 maximum loss allowance is phased out for higher-income taxpayers. The phase-out AGI threshold is $100,000 and fully phased out at $150,000. Where both of the taxpayers own rental property, they essentially combine their passive income by getting married. This could cause them to exceed the $25,000 loss limit or increase their income, causing the $25,000 loss limit to be reduced and, in doing so, reduce the amount that can be deducted for the year. On the other hand, if one of them has losses and the other spouse’s passive income is positive, they would be able to offset the one spouse’s passive income with the other’s passive losses. The $25,000 loss allowance is not available to married taxpayers who file separate returns and who lived with their spouse at any time during the tax year.
There are a number of possible scenarios relating to combining passive income and losses that can have a significant impact after marriage. Contact this office to determine the impact based on your particular circumstances.
Education Credits – There are two education credit limitations that can come into play because of marriage:
• Both the Hope and Lifetime credits are phased out for higher-income taxpayers. Thus, combining incomes on a joint return may cause credits that were allowed as an unmarried individual to be phased out.
• The Lifetime Learning Credit is limited annually to $2,000 per family. Thus, married taxpayers can qualify for only a maximum credit of $2,000, where prior to marriage they could qualify for up to $2,000 each.
Child Care Credits – Where either or both individuals have child or dependent care expenses, getting married can result in some significant changes in the amount of the child care credit.
• Generally, married taxpayers qualify for the credit only if both spouses are employed. There are exceptions for disabled and student spouses. Thus, if only one has care expenses that would have qualified for the credit prior to marriage, those expenses will not qualify when filing jointly.
• The credit, which ranges from 35% to 20% of the care expense, is also reduced for higher-income taxpayers. So by combining incomes on a joint return, it may reduce the credit amount.
• The expenses subject to the child credit are limited to $3,000 for one child and $6,000 for two. Thus, married taxpayers can qualify for only a maximum of $6,000 of expenses, compared to $6,000 for each individual prior to getting married.
Home Mortgage Interest – Generally, home mortgage interest is only deductible on $1 million of home acquisition debt plus $100,000 of home equity debt. Where a couple both owned a home before marriage, they may possibly exceed those limits on their combined homes and, as a result, have a portion of their home mortgage interest deduction disallowed.
Beneficiaries, Title to Property and Wills – Many unmarried individuals will have a parent, sibling, child or other relative designated as the beneficiary for their IRAs, annuities, pension plans and insurance policies. They may also hold title to property in some form of joint ownership with an individual other than their new spouse. These items, and wills and trusts that were drawn up as an unmarried individual, should be reviewed and amended accordingly.
Capital Gains & CG Rates – Capital gains rates are income dependent. Rates are currently 0% and 15% depending on a taxpayer’s taxable income. Thus, a married couple with combined incomes could be subject to a higher capital gains tax than they would have had filing as unmarried. Therefore, consideration for selling capital assets in the year prior to marriage may be appropriate, especially if the one with the potential sale has little other income.
Taxation on Dependent Children – Some years ago, Congress created what is referred to as the “Kiddie Tax” to discourage taxpayers from placing their investment accounts under their child’s name to take advantage of a child’s lower tax bracket. Thus, children are generally taxed on most of their investment income at their parent’s marginal tax rate. A result of combining newlyweds’ incomes on a joint return may be that the tax of a child subject to the Kiddie Tax rules is increased as well.
It may be appropriate to consult with this office before tying the knot to make sure that the tax aspects based on your particular issues are fully understood.
Birth or Adoption of a Child |
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The birth or adoption of a child is a joyous occasion for the new parents, siblings, grandparents and other family members. A birth or adoption also brings significant life style changes and tax implications for the family. The tax code includes numerous provisions dealing with children:
• Tax Exemptions
• Education Savings Plans
• Filing Status
• Child Care Credit
• Child Tax Credit
• Earned Income Credit
• Medical Expenses
• Adoption Credit
Tax Exemption – A taxpayer who files a federal tax return and is not someone else’s dependent is allowed an exemption for themselves, their spouse, and each of their dependents. An exemption reduces a taxpayer’s taxable income for the year, and the inflation adjusted exemption amount for 2009 is $3,650. What an exemption means to a specific taxpayer in terms of tax savings depends upon the individual’s tax bracket. Most taxpayers are in the 15% and 25% brackets. Thus, for example, a taxpayer in the 25% tax bracket would save $913 ($3,650 x 25%) in federal taxes because of the additional exemption. For higher-income taxpayers and those affected by the alternative minimum tax (AMT), the exemption amount may be reduced or not allowed at all.
Children are generally dependents of their parent(s), and the new parent(s) will be able to claim an additional $3,650 (2009) personal exemption for the newborn or adopted child. The full amount of the exemption is allowed regardless of when during the year the child was born (see special rules for adopted children below). In other words, the parent(s) will receive the full exemption (not prorated for the year) whether the child was born on January 1st of the year or December 31st. You may recall those media stories every January 1st about the first child born in your local hospital for the New Year. Although the new parent(s) got all the attention for having the first born in the New Year, they also lost a $3,650 (2009) tax deduction that they would have had if the child had been born on December 31st. The exemption cannot be split between two taxpayers, so if the new parents are unwed, the dependency–and 100% of the tax deduction for the exemption–will generally go to the child’s custodial parent.
Adopted Children – An adopted child is always treated as the taxpayer’s own child. An adopted child includes a child lawfully placed with the taxpayer for legal adoption. Generally, a taxpayer is allowed an exemption for an adopted child, provided the child is both younger than the adoptive parent and is under the age of 19 or a full-time student under the age of 24. There are special rules for foreign adopted children; please call for additional information.
Filing Status – If you are married and have been filing a Joint return, the birth or adoption of a child will not change your filing status. But if you are unmarried and have been filing your tax returns using the Single status, the addition of a child to your household may allow you to use the Head of Household filing status. Eligible Head of Household filers are allowed increased tax benefits. For example, the 2009 federal standard deduction, which is claimed in lieu of itemizing deductions, is $8,350 for Head of Household vs. $5,700 for Single status. Many phase outs of various deductions and credits have higher-income thresholds for Head of Household filers than Single filers, which could result in the Head of Household filer claiming a bigger deduction or credit than a Single filer with the same income. Additionally, the ranges of income are wider for most federal tax rates for Heads of Households than for Singles. For example, a taxpayer with $45,500 of taxable income in 2009 would still be in the 15% tax bracket if filing as Head of Household, but would be in the 25% bracket if filing Single. Thus, the Head of Household filer would pay less tax.
Generally, an unmarried taxpayer can claim the Head of Household status if the taxpayer is a U.S. citizen or resident and pays more than half of the cost of maintaining as his or her home a household which is the main home for more than half the year of a qualifying child, or for a child born during the year, the period during which the child lived in the home. The Head of Household status may also apply when a home is maintained for other qualifying relatives or when certain married individuals who are considered unmarried maintain a household for an eligible child. Please call for details.
Child Tax Credit – Generally, for years through 2010, taxpayers are allowed a tax credit of $1,000 (will drop to $600 after 2010 without Congressional action) for each qualifying child. A qualifying child is one that is under the age of 17 at the end of the year, is not self-supporting, who lived with the taxpayer over half the year and is a U.S. Citizen or national. Children who were born during the year are treated as living with the taxpayer for over half the year even if born in the last half of the year. This credit is generally nonrefundable except for certain low-income taxpayers. Nonrefundable means it can be used to reduce your income tax to zero, but any additional credit is lost. Thus, a qualifying taxpayer with a tax liability of $900 and a child credit of $1,000 would be able to reduce their tax liability to zero, but the $100 excess credit would be lost. The allowable credit does offset the alternative minimum tax (AMT) and the credit is phased out for higher-income taxpayers. The income phase-out threshold for married taxpayers is $110,000 and $75,000 for unmarried taxpayers.
Adopted child - An adopted child is always treated as the taxpayer’s own child. An adopted child includes a child lawfully placed with the taxpayer for legal adoption. In the case of foreign adoptions, if the taxpayer is a U.S. citizen or U.S. national and the adopted child lived with the taxpayer all of the tax year as a member of the taxpayer’s household, that child is treated as being a U.S. citizen, national or resident.
Medical Expenses – The birth of a child is usually accompanied by medical expenses for the care of the mother and the newborn child. Those expenses not reimbursed by insurance or other reimbursement arrangements are added to the taxpayer’s other medical expenses for the year, and deducted as an itemized medical expense to the extent the medical expenses exceed 7½% (10% for those subject to the AMT) of his or her adjusted gross income (AGI).
Where couples are unable to conceive by natural means, some of the artificial methods that have been developed are deductible and some are not. Although not specifically addressed in the tax code or regulations, in vitro fertilization performed on the taxpayer claiming the expense is deductible since the tax code specifically allows procedures that affect the structure or function of the body. IRS has ruled privately that a woman who can't conceive children using her own eggs may claim a medical expense deduction for the costs of obtaining an egg donor, including associated legal costs. The office of IRS Chief Council provided some guidance related to surrogate mother expenses: The tax code allows a taxpayer to deduct the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, the taxpayer's spouse, or the taxpayer's dependents. A surrogate mother is neither the taxpayer nor the taxpayer's spouse, and typically is not a dependent of the taxpayer. Nor is an unborn child a dependent. Thus, medical expenses paid for a surrogate mother and her unborn child would not qualify as a deduction.
Please call this office for more information related to deductible child birth expenses and future medical expenses of the children.
Education Savings Plans – Along with the newborn or adopted child is the future obligation to educate the child. It is never too soon to start thinking about saving for future educational expenses. The tax code provides two tax-favored plans to save for a child’s education. One is called a Coverdell Education Savings Account and the other is the Sec. 529 Plan (also referred to as a Qualified State Tuition Plan). Neither plan provides for a current tax deduction, but both provide for tax-free earnings when the funds are used for the prescribed education expenses. The three major differences in the plans are the amounts that can be contributed, which education is covered, and who has control of the funds. Contributions to the Coverdell account are limited to $2,000 per year per future student, whereas the contributions to a Sec. 529 plan are only limited by the projected cost of the future education. Coverdell qualified education includes kindergarten through post-secondary education, while Sec. 529 qualified education only includes college (post-secondary) education. Control of the Coverdell Account reverts to the child when the child reaches maturity, while the Sec. 529 plan remains under the control of the contributor. There are other important details relating to each plan, and a consultation appointment is recommended before embarking on a plan.
Child Care Credit – For working parents, the birth or adoption of a child can lead to the need for child care when the parent resumes their employment. A nonrefundable tax credit may be available for the expenses that are incurred for the care of a child (who generally must be under 13 years of age), disabled child, spouse, or other dependent while the taxpayer is gainfully employed (or is job seeking). In addition, employer dependent care assistance programs allow employees to exclude from income certain payments expended for child and dependent care.
Generally, the credit is 20% of the cost of the care with a maximum expense limit of $3,000 for one child and $6,000 for two or more. However, for lower-income taxpayers, the credit percentage can be as high as 35%.
The expenses that are taken into account for the credit are limited to a taxpayer’s earned income (i.e. income from working), and must be reduced by the amount a taxpayer excludes from gross income under an employer-provided dependent care assistance plan. Generally, self-employed taxpayers use the net earnings on Schedule C as earned income.
For taxpayers who file joint returns, the expense is limited to the earned income of the lower paid spouse, so generally both parents must be working or looking for work. Special rules allow a spouse who is disabled or a full-time student to qualify as having earnings when they otherwise have none, thus permitting the couple to claim some credit.
There has been some indication that this credit will be substantially increased under the Obama administration.
Earned Income Credit - The Earned Income Tax Credit (EIC) provides a refundable tax credit for people who work, but have lower incomes. Qualifying taxpayers may receive a refund even if they have had no income tax withheld. Each year, the credit and income limits are adjusted for inflation. If a taxpayer qualifies, this credit could be worth up to $5,028 for 2009. Thus, a qualifying taxpayer will pay less federal tax or could even get a larger refund. While taxpayers without children may qualify for the EIC, the potential amount of the credit is significantly more for eligible taxpayers who have one or more qualifying children. These taxpayers are also allowed to earn over 2½ times more income before the credit is phased out than workers without qualifying children.
Based on IRS statistics, in 2005, over 22 million taxpayers received $41.4 billion dollars in EIC. The IRS estimates 20 to 25% percent of people who qualify for the credit do not claim it.
Adoption Credit - Adoptive parents may be able to claim a dollar-for-dollar tax credit for the “qualified” expenses of adopting a child – up to $12,150 for 2009 ($11,650 for 2008) for each adopted child. That is equivalent to a deduction of over $48,500 for a taxpayer in the 25% tax bracket. The credit is a nonrefundable credit that cannot exceed the sum of a taxpayer’s regular and alternative minimum taxes. However, any unused credit can be carried forward up to 5 years.
In addition, if the employer has an adoption assistance program, a taxpayer may be able to exclude up to $12,150 for 2009 ($11,650 for 2008) of qualified adoption expenses paid by an employer from his or her gross income. Both the credit and the exclusion can be claimed but not for the same expenses.
The credit is phased out if the taxpayer's income (modified AGI) exceeds a threshold amount and is fully eliminated when AGI reaches the threshold cap. These values are annually adjusted for inflation, and for 2009, the threshold income is $182,180 and the threshold cap is $222,180.
Qualified adoption expenses include reasonable and necessary adoption fees, court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging) while away from home, and other expenses directly related to the legal adoption of an “eligible child.” However, the expenses do not include those to adopt a spouse’s child, surrogate mother expenses, and adoption arrangements that are in violation of state or federal laws. Expenses in connection with an unsuccessful attempt to adopt an eligible child before successfully finalizing the adoption of another child can qualify. Expenses connected with a foreign adoption can only qualify if the child is actually adopted.
An “eligible child” is a child under the age of 18 at the time the qualified adoption expense is paid. If the child turned 18 during the year, the child is an eligible child for the part of the year he or she is under age 18. A person who is physically or mentally incapable of caring for him or herself is also eligible, regardless of age.
There are additional rules related to adopting “special needs” children. Please call this office if you have questions regarding “special needs” adoptions or how the adoption credit will affect your unique circumstances.
It is just about everyone’s dream to own their own home. Buying your first home can seem like an enormous task. There are a great number of issues to deal with. They include the emotional trauma of a lifestyle change, financial aspects, tax implications and legal considerations. The process may seem a bit overwhelming, but everyone has to go through it. There are many books written on the subject and you certainly should approach the process with your eyes wide open and as prepared as possible for the undertaking. The process from start to finish will consume a great deal of your time. The following are some tips to help you down the path to home ownership.
• Are You Ready to Buy a Home?
• Home Ownership vs. Renting
• Tax Benefits
• How Much of a Home Can You Afford?
• Location, Size and Amenities
• Selecting a Real Estate Agent
• Creditworthiness
• Shopping for a Loan
• Down Payment
• Holding Title to Your Home
• Maintaining Home Improvement Records
Are You Ready to Buy a Home?
This is the first question that needs to be answered before making a home purchase. There is no need to expend the energy and time it takes to find, finance, acquire, and move into a home if you are not ready. Ask yourself the following questions:
• Do I have a steady source of income (from a job or business)?
• Have I been employed on a regular basis for the last 2-3 years?
• Is my current income reliable?
• Do I have a good record of paying my bills?
• Do I have few outstanding long-term debts like car payments?
• Do I have money available for a down payment?
• Am I credit worthy enough to qualify for home financing?
• Do I have the ability to pay a mortgage every month, plus additional costs?
If you can answer "yes" to these questions, you are probably ready to buy your own home.
Home Ownership vs. Renting
There is a big difference between owning your own home and renting. Generally, renting is free of most home maintenance responsibilities other than cleaning and yard care and even the gardening is included with many rental agreements. But at the end of the rental agreement, you have nothing to show for all those rental dollars that you shelled out, and you are generally at the mercy of the landlord. You have also helped the landlord pay down his mortgage and build his equity instead of yours. That’s not to say home ownership is for everyone; many prefer a lifestyle unencumbered by the responsibilities of home ownership.
On the other hand, a home purchase provides significant benefits, some immediate and some long-term. When you make a mortgage payment, you are building equity. And that's an investment. Owning a home also qualifies you for tax breaks that assist you in dealing with your new financial responsibilities - like insurance, real estate taxes, and upkeep - which can be substantial. But given the freedom, stability, and security of owning your own home, they are generally worth it.
Tax Benefits
The tax benefits available with home ownership can greatly reduce the cost of ownership. An individual who rents cannot deduct the cost of the rent on his or her tax return. However, if you are buying the home, the mortgage interest and property taxes (1) are a tax deduction (when itemizing) which provides considerable benefits and can substantially offset the cost of owning the home. This is best explained by example.
Illustration: Let’s assume that you are a married couple filing jointly. Your mortgage payment is $1,500 per month ($18,000 per year) and the property taxes for the year are $5,000. In the first years after purchasing your home, the mortgage payment is primarily interest, which means most of the payment will be tax-deductible (so we will use $17,000 of the mortgage payment as deductible home mortgage interest). Assume your “other” deductible itemized deductions (medical, charity, other taxes and miscellaneous) for the year after AGI adjustments totaled $4,000 and your standard deduction for the year would have been $11,400. Assuming that you are in the 25% tax bracket, your tax savings can be determined as follows:
Deductible Interest $17,000
Property Taxes (1) 5,000
Other Itemized Deductions 4,000
Total Itemized Deductions 26,000
Standard Deduction (2009) <11,400>
Net Increase in Deductions $15,000
Net Tax Savings (25% Tax Bracket) $3,750
This benefit generally can be more or less based on a number of factors. Had this illustration been for a single taxpayer with a standard deduction of only half that of the joint filing taxpayers, the savings would have been $5,050! Tax bracket also has a big impact. Had the illustration been for a single individual in the 35% tax bracket, the savings would have been $7,070.
You can project your savings by substituting your estimated deductible interest and taxes, using the standard deduction that you would use if not itemizing and your marginal tax rate (2).
(1) Property taxes are deductible by everyone except those subject to the alternative minimum tax (AMT). To the extent you might be subject to the AMT, property taxes will not provide any tax benefit.
(2) Frequently, a taxpayer’s taxable income before and after the increase in deductions will straddle two tax brackets and result in a blended marginal rate.
Keep in mind that the annual cost of the home will be more than mortgage payments and taxes. The lender will require the home to be insured for fire and possibly flood. Your utility bills may increase and an allowance for home maintenance and repairs should be set aside.
Determine How Much of a Home You Can Afford
First of all, you will need enough up-front cash to cover the down payment and closing costs. In addition, unless you are purchasing a furnished model, you will need some amount of cash to cover curtains, paint, and whatever other modifications you think are necessary to occupy the home. Don’t forget that once you buy the house, you will have expenses moving there.
Before you start looking for a home, the following two things should be determined:
What Can You Afford: Before anything else, figure out how much you can comfortably afford for monthly home expenses. That will include the mortgage payment, taxes, insurance, possible increased utilities and an allowance for home maintenance. Formulate a budget that includes all of your other monthly expenses less those expenses attributable to your current rental. Be careful not to overlook transportation, entertainment, medical expenses, eating out, etc., unless you plan to change your lifestyle. Use that budget to determine how much you can afford monthly for housing.
What Loan Amount Will You Qualify For: Unless you have affluent family members, you will need to determine the maximum loan amount that you will qualify for. A potential lender considers your debt-to-income ratio, which is a comparison of your gross (pre-tax) income to housing and non-housing expenses. Non-housing expenses include long-term debts such as car or student loan payments, alimony, or child support. According to the FHA, monthly mortgage payments should be no more than 29% of gross income, while the mortgage payment, combined with non-housing expenses, should total no more than 41% of income. The lender also considers cash available for down payment and closing costs, credit history, etc. when determining your maximum loan amount.
You may wish to get pre-qualified for a mortgage before you make an offer to a seller. Having been previously approved by a mortgage lender removes a large amount of uncertainty in the seller's mind, and increases the likelihood of a quick closing. With pre-qualification, you'll be in a stronger position to negotiate a better price on the house that you would like to buy. Prequalification is quick and easy. Some lenders charge for the service while others don't. It will also let you know ahead of time how large of a loan you are qualified for.
Location, Size and Amenities
Before you start searching for that perfect home, there are several things you need to determine that will save yourself hours of wasted time. Figure out the type of house that you want early in the process and set your requirements. This cuts out a lot of the guesswork and makes it easier for your real estate agent to find something suitable. Things to consider are:
Size: How big of a home do you need? How many bedrooms? Will the family size be increasing?
Amenities: Narrow your search by specifying the amenities that you require, such as the number of bathrooms, a pool, 2 or 3-car garage, fireplace, yard size, etc. Categorize these items by the need, from your minimum requirements to a wish list.
Location: Select a community that you will be comfortable in. Many people choose communities based on the schools. Do you want access to close shopping and public transportation or a more rural area? How close do you want to be to your place of business or family?
Selecting a Real Estate Agent
Typically, the first person you consult about buying a home is a real estate agent or broker. Although real estate brokers provide helpful advice on many aspects of home buying, they may serve the interests of the seller and not your interests as the buyer. The most common practice is for the seller to hire the broker to find someone who will be willing to buy the home on terms and conditions that are acceptable to the seller. Therefore, the real estate broker you are dealing with may also represent the seller. However, you can hire your own real estate broker, known as a buyer’s broker, to represent your interests. Also, in some states, agents and brokers are allowed to represent both the buyer and seller.
Sometimes, the real estate broker will offer to help you obtain a mortgage loan. He or she may also recommend that you deal with a particular lender, title company and attorney or settlement/closing agent. You are not required to follow the real estate broker’s recommendation. You should compare the costs and services offered by other providers with those recommended by the real estate broker. Make sure that you do your research.
Find an agent by inquiring around with associates and friends for recommendations. If you have multiple recommendations, interview them before choosing one. Look for an agent who listens well and fully understands your needs. Pick one who is familiar with the area in which you wish to purchase your home. You want to choose an agent that can provide all the knowledge and services that you need.
Creditworthiness
When you’re applying for credit - whether it’s a credit card, a car loan, a personal loan or a home mortgage - lenders want to know your credit risk level. In other words, “If I give this person a loan or credit card, how likely is it that I will get paid back on time?”
There are three major credit reporting agencies (Equifax, Experian and TransUnion) in the United States that maintain records of your use of credit and other information about you. These records are called credit reports, and lenders will want to check your credit report when you apply for credit. In most cases, lenders will also want to know your credit score. A credit score is a number that summarizes your credit risk, based on a snapshot of your credit report at a particular point in time. A credit score helps lenders evaluate your credit report and estimate your credit risk. Your credit score influences the credit that is available to you and the terms (interest rate, etc.) that the lenders offer you. It’s a vital part of your credit health. If your credit score is low, you will generally end up with a less favorable home mortgage. The interest rate most likely will be higher, which will make the monthly home payments higher.
If you are in the planning stages of acquiring a home, you may wish to check your credit score before applying for a loan. If you find errors in the report, you should take steps to have those errors corrected to improve your score.
The most commonly encountered credit score is your FICO® score, which is easy to check online. Although in most cases, there will be a charge to obtain the FICO® score. An important time to check your FICO® score is six months or so before you plan to purchase a home. This will give you enough time to verify the information on your credit report, correct errors if there are any, and take actions to improve your FICO® score if necessary. In general, any time you are applying for credit, taking out a new loan or changing your credit mix is a good time to check your FICO® score. Improving your FICO score can help you:
• Get better credit offers;
• Lower your interest rates; and
• Speed up credit approvals.
The payoff from a better FICO® score can be big. For example, with a 30-year fixed mortgage of $150,000, you could save approximately $165,000 over the life of the loan - or $459 on each monthly payment - by first improving your FICO® score from 550 to 720.*
* Based on average national interest rates as of September 2007.
Shopping for a Loan
Your choice of lender and type of loan will influence not only your settlement costs, but also the monthly cost of your mortgage loan. There are many different types of lenders and loans you can choose from. You may be familiar with banks, savings associations, mortgage companies and credit unions, many of which provide home mortgage loans. Also check out the yellow pages for a listing of some mortgage lenders or your local newspaper for a listing of rates.
• Mortgage Brokers - Some companies (known as "mortgage brokers") offer to find you a mortgage lender willing to make you a loan. A mortgage broker may operate as an independent business and may not be operating as your "agent" or representative. Your mortgage broker may be paid by the lender, you as the borrower, or both. You may wish to ask about the fees that the mortgage broker will receive for its services
• Government Programs - You may be eligible for a loan insured through the Federal Housing Administration ("FHA") or guaranteed by the Department of Veterans Affairs or similar programs operated by cities or states. These programs may require a smaller down payment. Ask lenders about these programs. You can get more information about these programs from the agencies that run them.
• Computer Loan Origination Systems (CLOs) - CLOs are computer terminals sometimes available in real estate offices or other locations to help you sort through the various types of loans offered by different lenders. The CLO operator may charge a fee for the services the CLO offers. This fee may be paid by you or by the lender that you select.
Types of Loans - Loans can have a fixed or variable interest rate. Fixed rate loans have the same principal and interest payments during the loan term. Variable rate loans can have any one of a number of "indexes" and "margins" which determine how and when the rate and payment amount change. If you apply for a variable rate loan, also known as an adjustable rate mortgage ("ARM"), a disclosure and booklet required by the Truth in Lending Act will further describe the ARM. Most loans can be repaid over a term of 30 years or less and have equal monthly payments. The amounts can change from time to time on an ARM depending on changes in the interest rate. Some loans have short terms and a large final payment called a "balloon." You should shop for the type of home mortgage loan terms that best suit your needs.
Interest Rate, "Points" & Other Fees - The price of a home mortgage loan is usually stated in terms of an interest rate, points and other fees. A "point" is a fee that equals 1 percent of the loan amount. Points are usually paid to the lender, mortgage broker, or both, at the settlement or upon the completion of the escrow. Often, you can pay fewer points in exchange for a higher interest rate or more points for a lower rate. Ask your lender or mortgage broker about points and other fees.
A document called the Truth in Lending Disclosure Statement will show you the "Annual Percentage Rate" ("APR") and other payment information for the loan you have applied for. The APR takes into account not only the interest rate, but also the points, mortgage broker fees and certain other fees that have to be paid. Ask for the APR before you apply to help you shop for the loan that is best for you. Also ask if your loan will have a charge or a fee for paying all or part of the loan before the payment is due, otherwise known as the prepayment penalty. You may be able to negotiate the terms of the prepayment penalty.
Lender-Required Settlement Costs - Your lender may require you to obtain certain settlement services, such as a new survey, mortgage insurance or title insurance. They may also order and charge you for other settlement-related services, such as the appraisal or credit report. A lender may also charge other fees, such as fees for loan processing, document preparation, underwriting, flood certification or an application fee. You may wish to ask for an estimate of fees and settlement costs before choosing a lender. Some lenders offer "no cost" or "no point" loans but normally cover these fees or costs by charging a higher interest rate.
Comparing Loan Costs - Comparing APRs may be an effective way to shop for a loan. However, you must compare similar loan products for the same loan amount. For example, compare two 30-year fixed rate loans for $100,000. Loan A with an APR of 8.35% is less costly than Loan B with an APR of 8.65% over the loan term. However, before you decide on a loan, consider the up-front cash you will be required to pay for each of the two loans as well.
Another effective shopping technique is to compare identical loans with different up-front points and other fees. For example, if you are offered two 30-year fixed rate loans for $100,000 and at 8%, the monthly payments are the same, but the up-front costs are different:
Loan A - 2 points ($2,000) and lender required costs of $1,800 = $3,800 in costs.
Loan B - 2 1/4 points ($2,250) and lender required costs of $1,200 = $3,450 in costs.
A comparison of the up-front costs shows Loan B requires $350 less in up-front cash than Loan A. However, your individual situation (how long you plan to stay in your house) and your tax situation (points can usually be deducted for the tax year that you purchase a house) may affect your choice of loans.
Lock-ins - "Locking in" your rate or points at the time of application or during the processing of your loan will keep the rate and/or points from changing until settlement or closing of the escrow process. Ask your lender if there is a fee to lock-in the rate and whether the fee reduces the amount you have to pay for points. Find out how long the lock-in is good, what happens if it expires, and whether the lock-in fee is refundable if your application is rejected.
Tax and Insurance Payments - Your monthly mortgage payment will be used to repay the money you borrowed plus interest. Part of your monthly payment may be deposited into an "escrow account" (also known as a "reserve" or "impound" account) so your lender or servicer can pay your real estate taxes, property insurance, mortgage insurance and/or flood insurance. Ask your lender or mortgage broker if you will be required to set up an escrow or impound account for taxes and insurance payments.
Transfer of Your Loan - While you may start the loan process with a lender or mortgage broker, you could find that after settlement another company may be collecting the payments on your loan. Collecting loan payments is often known as "servicing" the loan. Your lender or broker will disclose whether it expects to service your loan or to transfer the servicing to someone else.
Mortgage Insurance - Private mortgage insurance (PMI) and government mortgage insurance protects the lender against default and enables the lender to make a loan which is considered a higher risk. Lenders often require mortgage insurance for loans where the down payment is less than 20% of the sales price. You may be billed monthly, annually, by an initial lump sum, or some combination of these practices for your mortgage insurance premium. Ask your lender if mortgage insurance is required and how much it will cost. Mortgage insurance should not be confused with mortgage life, credit life or disability insurance, which is designed to pay off a mortgage in the event of the borrower's death or disability.
You may also be offered "lender paid" mortgage insurance ("LPMI"). Under LPMI plans, the lender purchases the mortgage insurance and pays the premiums to the insurer. The lender will increase your interest rate to pay for the premiums - but LPMI may reduce your settlement costs. You cannot cancel LPMI or government mortgage insurance during the life of your loan. However, it may be possible to cancel private mortgage insurance at some point, such as when your loan balance is reduced to a certain amount. Before you commit to paying for mortgage insurance, find out the specific requirements for cancellation.
Flood Hazard Areas - Most lenders will not lend you money to buy a home in a flood hazard area unless you pay for flood insurance. Some government loan programs will not allow you to purchase a home that is located in a flood hazard area. Your lender may charge you a fee to check for flood hazards. You should be notified if flood insurance is required. If a change in flood insurance maps brings your home within a flood hazard area after your loan is made, your lender or servicer may require you to buy flood insurance at that time.
Down Payment
If you have the funds for a down payment and a good credit rating, this is probably a good time to purchase a home, since there is a large inventory of property available and the prices are lower than they have been for a number of years.
The typical down payment required for the purchase of a home is twenty percent of the purchase price. In the past, banking on steadily increasing home values, some creative financing arrangements required a much smaller down (some no down payment at all). However, with the decline in home values during 2008, these creative home loan arrangements are generally no longer available.
If you lack the ready cash for the down payment or are short on the amount you need, the following may be possible sources:
IRA Account - If you have an IRA account and you qualify as a first-time home buyer, tax law permits you to make up to a $10,000 penalty-free withdrawal from an IRA to purchase a home. (Please note that even though the withdrawal might be penalty-free, it is still taxable). The tax definition of a first-time homebuyer is quite different from the literal definition of a first-time homebuyer. As it turns out, you can qualify even if you owned a home before. Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement. To qualify for the first-time homebuyer penalty exception, the distribution must be used to pay qualified acquisition costs before the close of the 120th day after the distribution was received. When added to all of the taxpayer's prior qualified first-time homebuyer distributions, if any, the total distributions cannot be more than $10,000. If the taxpayer is married, both can withdraw up to $10,000.
Other Retirement Accounts – The penalty-free withdrawal from IRA accounts does not apply to other types of retirement accounts. However, funds can be rolled from a qualified plan to an IRA and then a penalty-free distribution can be taken from the IRA.
Gifts – Often parents or other relatives can assist a potential homebuyer by gifting them the funds to help with the down payment.
First-Time Homebuyer Credit – For home purchases made after April 8, 2008 and before July 1, 2009, a first-time homebuyer (no present ownership interest in a principal residence in the U.S. during the 3-year period before purchasing the home) can receive a refundable tax credit equal to 10% of the home’s purchase price, but capped at $7,500 ($3,750 for married taxpayers filing separately).
The credit is essentially an interest-free loan that must be paid back. The repayment will be in the form of an additional tax amount on the homeowner’s federal tax returns for 15 years. If the home is sold or no longer used as a primary residence before the end of the 15-year period, the balance of the un-repaid credit must be repaid in the year the home is sold or no longer used as the taxpayer’s primary residence. There are special rules for divorced taxpayers, deceased taxpayers, and where the un-repaid credit exceeds the gain when the home is sold. The credit is phased out for high-income taxpayers and not allowed for nonresident alien homeowners or homes financed with tax-exempt mortgage bonds or property purchased from a related party.
Holding Title to Your Home
You also need to consider how you intend to hold title to the home. Surprisingly, many home purchasers don't give much attention to the question even though the manner in which the title is held can have far-reaching ramifications.
The best way to come to a decision about the title is to consult with a real estate attorney. Before you do that, however, you may want a little background on the more prevalent title-holding methods:
• Title held in the name of one individual. Single individuals would probably be the most likely candidates for this method of holding title. However, married individuals may also, for one reason or another, choose to take title individually rather than with their spouse. When the owner of the property dies, probate is necessary. However, the property takes on a new value for the beneficiary - equal to its fair market value at the date of the original owner's death.
• Joint tenancy with right of survivorship. Under this form of ownership, all (two or more) owners hold title to the property. Each owns an equal share of the property. When one owner dies, the others become owners of the decedent's portion. An advantage of joint tenancy is that it cuts probate costs since the decedent's portion of the property normally reverts to the remaining joint tenants automatically (ownership recording, of course, need to be changed). The basis of the decedent's part is revalued at the date of death.
• Community property. Married couples in community property states of Arizona, California, Idaho, Nevada, New Mexico, Louisiana, Texas, Washington and Wisconsin can claim community title to property. Under community property rules, each spouse owns half of the property and each spouse can pass his/her portion either to the other spouse or to someone else. An advantage of community property is that when it is willed to a surviving spouse, the entire property gets revalued to its fair market value at the date of the decedent spouse's death.
Other methods of holding title, like tenancy in common or holding property in trust, are also available. All have their "special" pros and cons. Some community property states also have special methods of holding title such as California’s “community property with right of survivorship,” which combines the tax benefits of holding title as community property including a double step-up in basis with the ease of property transfer available to the survivor of joint tenancy property. Before making your final decision, take some time to check out the different methods of holding title to determine what’s best for you.
Maintaining Home Cost & Improvement Records
One of the benefits of home ownership is the ability to exclude up to $250,000 ($500,000 for a married couple) of gain from the sale of the home. To qualify for the exclusion, taxpayers must meet the ownership and use tests. This means that during the 5-year period ending on the date of the sale, taxpayers must have:
1) Owned the home for at least 2 years (if a joint return, only one spouse needs to meet the ownership test), and
2) Except for short temporary absences, lived in (used) the home as their main home for at least 2 years.
The required 2 years of ownership and use during the 5-year period ending on the date of the sale does not have to be continuous. Taxpayers meet the tests if they can show that they owned and lived in the property as their main home for either 24 full months or 730 days during the 5-year period ending on the date of sale. Where taxpayers do not meet the two-out-of-five use and ownership requirements, they may qualify for a reduced exclusion if the home was sold as a result of unforeseen circumstances.
Maintaining good records will help reduce any future gain and minimize any potential tax when the home is sold. Therefore, it is important to keep a copy of your purchase documents that itemize the costs of purchasing the property, along with substantiation for all subsequent improvements to the home. Don’t make the mistake of thinking that the $250,000 or $500,000 gain exclusion will cover all subsequent appreciation in value of the home.
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