June, 2007 Tax Newsletter

A Couple of Real Estate Tidbits of Current Interest

Mortgage Interest Deduction and the AMT

There are two definitions that apply to mortgage interest – “qualified residence interest” that applies to the regular tax system and “qualified housing interest” that applies to the AMT (alternative minimum tax) system.  The former is broader in scope than the latter.

Qualified residence interest permits a deduction for acquisition indebtedness ( debt incurred to acquire, construct, or substantially improve the taxpayer’s primary and one other residence) and also home equity indebtedness.  The latter is any indebtedness other than acquisition indebtedness.  Acquisition debt is limited to a total of $1,000,000 for all properties.  Home equity debt is limited to $100,000.  One caveat:  The home equity debt when added to the acquisition debt cannot exceed the total value of the home when the loan is incurred.  The interest on any debt amount in excess of value is not deductible.  Both acquisition and home equity debt must be secured by the residence the loan was used for.

The AMT’s qualified housing interest definition, on the other hand, is interest on debt incurred to acquire, construct or improve the taxpayer’s primary and one other residence.  It excludes interest on loans not made for these purposes.  This effectively eliminates the deduction for interest on home equity debt for AMT purposes thereby increasing the possibility that the AMT might kick in.  Care must be exercised when refinancing.  It is a common practice when refinancing to pull out additional built-up equity to pay off bills, make large purchases, take a vacation, etc. To the extent that the debt resulting from the refinancing exceeds the outstanding debt immediately prior to the refinancing, the excess would constitute home equity debt which, if under $100,000, would be deductible for regular tax, but not for the AMT.   A major exception to this is where all or a portion of the refinancing debt is used to substantially improve the residence, in which case it would constitute acquisition debt.  Therefore, one must be mindful of where he or she stands with regard to the $100,000 limit.

The AMT makes it critical that borrowers structure their mortgage debt so it qualifies as acquisition debt, which is subject to higher debt limits and no AMT adjustment.

NOTE:  The IRS currently does not have the wherewithal to track and differentiate a taxpayer’s acquisition debt and home equity debt.  There are reports that beginning in the very near future, Form 1098, reporting mortgage interest payments, will be re-designed to provide more information to the IRS regarding refinances.  Stay tuned.

Real Estate Short Sales

For the past several years, short sales of real estate were virtually unheard of.  More recently, due to falling home prices and rising mortgage payments for people with adjustable rate loans, these have come to the forefront.

A short sale is a situation in which a mortgage lender allows a financially strapped homeowner to try to sell their home to avoid foreclosure, even if the market value of the home is less than the mortgage balance.  The usual profile is a homeowner with little or no equity in the home and home values are not appreciating.  In other words, the home’s value does not support the mortgage balance plus selling costs, such as title company fees and agent commissions.   If the owner has an offer in hand, he may be able to persuade the lender to allow the sale.  The property is frequently listed as “short sale - subject to lender’s approval”, thereby putting the prospective buyer on notice..

Typically the owner and his agent send a letter to the lender asking him to approve the sale for less than the mortgage balance.  Included with the letter is a copy of the offer and a statement from the broker as to the market value of the property (with supporting documentation).  The lender may require an independent appraisal.   He will undoubtedly ask for the borrower’s financial statement and check his credit report before allowing the sale.  It is very important that the seller’s agent be very knowledgeable in short sales, as he will be in constant communication with the lender during the hoped-for approval process.

It is this process that constitutes the downside to a prospective buyer.  It can take far longer than a normal sale as the lender performs his due diligence.  From the lender’s standpoint, approval of a short sale may be a prudent business decision.  When compared to a foreclosure, a short sale has fewer costs, including possible eviction, clean-up, and marketing and selling expenses.  From the seller’s standpoint, the biggest advantage is avoiding foreclosure, which can do more damage to a credit report than a short sale.  A potentially big disadvantage to the seller is that a short sale at a price less than the outstanding mortgage is reported to the seller as taxable income from discharge of indebtedness.  It should be noted that legislation has recently been proposed in Congress that would exclude mortgage debt forgiven by the lender from taxable income.  Stay tuned.