Paula Iacovissi, CPA is an audit partner at the accounting, tax and consulting firm Citrin Cooperman. Paula discusses the tax advantages of buying and selling a home. Paula breaks down multiple buying and selling scenarios  including rent versus buy as well as different individual income and tax profiles. Ever heard of the AMT and how it may affect you? Read on.

Paula Iacovissi, CPA is an audit partner at the accounting, tax and consulting firm Citrin Cooperman. Paula’s clients range from rapidly growing entities to long-established organizations in the construction, real estate development, investment, syndication and management industries. Throughout her 30-year career, Paula has assisted clients in securing financing, mergers and acquisitions, business succession, tax planning, restructurings and tax-free exchanges. 

Before we get into the interview, you suggested getting started with the definition of a “qualified home.”
A qualified home is very interesting because it really lends itself to a lot of flexibility. It can be a traditional house with a backyard or a condo or co-op. Mobile homes qualify, believe it or not, even though they are not in one fixed place as do boats. So, if someone wants to be adventuresome and sell their condo or co-op in Manhattan and live off of a boat; as long as it has sleeping, cooking and toilet facilities, it qualifies as a home and your interest could be deductible. It is pretty interesting that the IRS provides such flexibility in its definition of a home.

Can you discuss buying versus renting in light of tax deductions?
Renting has virtually zero tax deductions. On the upside, you really do not have any cost of maintenance, repairs or ownership responsibilities.

Buying. If you have the down payment available, it is a good way to go for long-term investment from a tax planning point of view. The domicile can be anywhere in the world, by the way. You can get an interest deduction for a primary home in another country. As many people know, you have the interest deduction of up to $1 million of capital, so in other words, you can’t by a home for $10 million, borrow $9 million and get a deduction for all of the $9 million worth of interest. It is only up to $1 million and that is very important to keep in mind.

Real estate taxes do not have any limitations and are totally deductible.

That is another very important thing to consider when looking at your finances – how much you are going to borrow, but also how much of it you are going to get back. On a long-term basis, buying is definitely a better way to go because as you pay down the mortgage, you are building assets and it is a form of “forced savings” that you can tap into later on to help you with other expenses or lifestyle matters that you may want to address. Specifically, there are two features of equity build. The first is that as you pay down your mortgage, you are saving money because you get some of it back in taxes. You are also paying down a portion of the principal, so your equity in that home is going up. The second feature of equity build is the benefit of property appreciation, which historically has not been an issue, but one can never predict the economy in various markets.

Another thing to consider about buying is that depending on your tax situation, people should speak to their advisor about the Alternative Minimum Tax (AMT). The AMT is a second calculation of your tax liability where it takes your regular tax as calculated with all of your itemized deductions and then re-calculates the tax in another fashion with certain adjustments to it. Those adjustments come up with limitations and if the AMT tax is higher than your regular tax, then you are considered to be “in the AMT,” which has cost you to lose the benefit of your real estate tax deduction. If you have been in the AMT and are in the AMT, you typically know it. It is something that is easily identifiable on your return.

Can you discuss the limitations on tax deductions for mortgages on both primary and secondary homes?
Up to $1 million, you are able to deduct taxes regardless of which home it is on. In addition, up to $100,000 of principal on an equity loan is deductible. If you want to borrow against the equity of your house for say, college education or short-term funding, up to $100,000 of the equity principal is deductible. The debt limitation is not per home, but per taxpayer. You can have the $1 million spread over two homes no matter how it is allocated.

The thing to consider about a secondary residence is that if that residence is 100% personal use, then the above applies. If the secondary residence becomes a vacation home that you rent out for part of the time, then there are different rules that apply as to which part of the mortgage is deductible and which part is not.

When you sell a primary residence, what are your capital gain exclusions?
Basic rule is that you have to have lived in the house for two of the last five years to exclude the capital gain. It also has to be your primary residence. Vacation homes or secondary homes do not qualify for this exclusion. So, if you have two homes that are pretty close to each other and you are planning on selling one, you might want to think about which one should be your primary residence.

The other thing to consider about the sale is that you do have a $500,000 exclusion of gain for married couples filing jointly and $250,000 for individuals. That means that if you sold a house for $2 million and it cost you $1 million, the first $500,000 of gain is tax free. The other $500,000 will be taxed at long-term capital gain rates assuming that you owned it more than one year.

Let’s take a hypothetical. You buy a primary home for $1 million and sell it for $2 million three years later. What are your tax consequences?
If you lived in it for two out of five years, then you can sell it and defer the gain. Say you decide to hold onto the house because you have been transferred to another city or another state and you are not sure that you are going to like it there. You can still sell your home as long as it is within the two out of five consecutive years.

Upon the sale, you are going to have your tax liability. So, assuming you have no mortgage on the house, if you sell the house for $2 million and it cost you $1 million, you will end up with $2 million in your pocket. The taxes on that $1 million of profit are as follows. If a New York City resident, the city and state taxes are about $40,000 each. This does not include the additional city and state transfer tax that is part of the closing costs. Then, your federal tax, which includes Obamacare and the capital gain rate, is 25% of $500,000, which is $125,000. So, you have a total tax of about $200,000 on the whole transaction.

The other thing to consider is that you have to make estimated payments for under-payment of taxes related to this gain. If you normally have no estimated payments made during the year because you have a W-2 and all of your taxes are withheld and all of a sudden you are going to have an additional income item, you should consider making estimated payments during the year to cover your tax liability. Be careful with that as well and put the money aside.

How do you advise clients in determining an appropriate budget for buying a home?
Typically, we do not advise on this topic because that is a very personal decision, but as far as mortgage payments are concerned, I would use 30% of income towards the mortgage plus maintenance payments as the guideline. I mean, can people go higher than that? They probably could, but it depends on what their lifestyle is and what their other costs are in relationship to their lifestyle.

Final thoughts?
The biggest disappointment with ownership is that if you are in the AMT, you really do lose a lot of the deductibility on the loan and on real estate taxes. Before people do buy, if they are counting on a tax savings to be able to afford the home, it is very important that they look at their tax status to see if that would put them in the AMT and if it does, then they are really losing the benefit of ownership.