TAX RESEARCH MEMORANDUM TO: LUIS V PLASCENCIA FROM: YOURA STUDENT SUBJECT: IMA TAXPAYER FILE DATE: DECEMBER 1, 2008 (UPDATED ON MARCH 1, 2009) FACTS Ima Taxpayer is contemplating purchasing real estate. She currently resides in an apartment and has never own any realty. Ima is a single taxpayer with no dependents. Ima cannot be claimed as a dependent on another taxpayer's tax return. Ms. Taxpayer is debating between buying realty in 2008 or in 2009. She is interested in learning about the tax benefits involved with buying real estate. Additionally, she would like to know if it would make a difference if she purchased the property in 2008 or 2009. ISSUES 1. What tax deductions are available for individuals with real estate? 2. Are there any requirements and limitations for tax deductions available for real estate? 3. What personal tax credits are available for individual who purchase real estate? 4. Are there any requirements and limitations for the personal tax credits for purchasing real estate? 5. What tax ramifications will Ima encounter if she later decides to sell her property? LEGAL DISCUSSION According to Internal Revenue Code 63, taxable income is computed by subtracting standard deduction under IRC 63(c) and exemptions under 151. The standard deduction is determined by the individual's filing status. For 2008, the standard deductions amounts are: $5,450 for single and married filing separately filers, $8,000 for head of household filers, $10,900 for married filing jointly and surviving spouses filers. These amounts are indexed for inflation each year. Individuals are allowed to claim itemized 2 deductions in lieu of the standard deduction under Sec. 63(d). Itemized deduction is a collection of personal deductions that are allowed. If the aggregate itemized deductions exceed the standard deduction amount, then the itemized deduction should be taken. Expenses that may be included in the itemized deductions groups are, but not limited to; medical expenses, certain interest expenses, certain taxes, charitable contributions, casualty and theft losses, and other miscellaneous expenses. Real estate taxes are included as itemized deductions under IRC 164(a)(1). The taxpayer claiming real estate taxes must be obligated to pay these taxes and must have paid these taxes during the tax year being claimed. Special rules apply at the date of the sale for "apportionment of taxes on real property between seller and purchaser" under Sec. 164(d). Generally, if the seller pays the real estate in the year of the sale, then the seller may deduct the real estate taxes in that tax year. However, if the buyer pays the real estate taxes in the year of the sale the individual may not deduct the taxes. Instead he or she is allowed an adjustment of the adjusted basis of the property under Treasury Regulation 1.164-6(b). According to IRC Sec. 163(h), individuals may not deduct personal interest. However, Sec. 163(h)(2)(D) and Sec. 163(h)(3) allows a deduction for "qualified residence interest". Qualified residence interest is defined under IRC 163h)(3)(A) as "acquisition indebtedness with respect to any qualified residence of the taxpayer" or "home equity indebtedness with respect to any qualified residence of the taxpayer". A "qualified residence" is a residence that is the taxpayer's primary residence and not used for rental purposes according to Sec. 163(h)(4)(A). Additionally, the taxpayer claiming the deduction should be the taxpayer liable to pay the interest. Interest on qualified residence is broken down into two types, "acquisition indebtedness" and "home equity indebtedness". Both have limitations in terms of the principal balance. Under IRC Sec. 163(h)(3)(B)(ii), the maximum "acquisition indebtedness" amount is limited to $1 million ($500,000 for married filing separately individuals). For example, let's say Ima purchases a personal residence for $2,000,000 and pays interest in the amount of $160,000 for that tax year. Her itemized deduction for interest 3 on acquisition indebtedness will be limited to $80,000 [$160,000 x ($1,000,000/$2,000,000)]. However, if Ima purchases property in the amount of $1,000,000 or less then she will be allowed to claim the total interest paid as an itemized deduction. The limitation for home equity indebtedness is $100,000 ($50,000 for married filing separate individuals) pursuant to Sec. 163((h)(3)(B)(ii). Also, mortgage insurance premiums paid on "acquisition indebtedness" are treated as interest under Sec. 163(h)(3)(E). The aforementioned discussion on the deductibility of real estate taxes and mortgage interest was for individuals who elect to claim itemized deductions in lieu of the standard deduction. However, during the 2008 Congress enacted the "Housing Assistance Tax Act of 2008" to provide equitable relief for nonitemizers. The Housing Assistance Tax Act of 2008 provided benefits for taxpayers who do not itemize and are paying real estate taxes. Accordingly, Internal Revenue Code 63(c)((1)(C) and 63(c)(7), allows individuals who are claiming standard deduction to increase their basic standard deduction amount by the lesser of real estate taxes paid during the tax year or $500 ($1,000 for married filing jointly taxpayers). This option is only available for tax years 2008 and 2009. Again, individuals claiming this deduction should be the individuals liable to pay those taxes. To encourage taxpayers to invest in realty, Congress provided a personal tax credit for individuals who purchase real estate as first time home buyers in the Housing Assistance Tax Act of 2008. According IRC Sec. 36 provides a refundable tax credit for first-time home buyers. "First-time home buyer" is defined in Sec. 36(c)(1) as "any individual if such individual (and if married, such individual's spouse) had no present ownership interest in a principal residence during the 3-year period ending on the date of the purchase of the principal residence". In other words, that taxpayer must have not own any property three years prior to purchasing the new property. For example, let's say that Ima purchased property on December 1, 2008. If she owned any property between November 30, 2005 and November 30, 2008, she will not be considered a first-time home buyer and be disqualified for this credit. If she did not own any property during that period or at any time during her life then she will be considered a first-time homebuyer and be eligible for this credit. 4 Another requirement that must be met is that the residence must be the taxpayer's primary personal residence and cannot be used for rental purposes under 36(c)(2). Additionally, the property cannot be purchased form a related party pursuant to Sec. 36(c)(3)(A)(i). There are two separate rules depending on which year the property is purchased. If the property is purchased during 2008, the credit is the lesser of 10% of the purchase price or $7,500 ($3,750 for married filing separately individuals) under Internal Revenue 36(a) and 36(b)(1) as amended by the Housing Assistance Tax Act of 2008. There is a recapture provision, that is, the credit will be paid back by the taxpayers on their subsequent tax returns beginning the second tax year the credit was claimed under Sec. 36(f). In other words, this is equivalent to an interest-free loan from the government. The recapture period is 15 years under Sec. 36(f)(7). During 2009, Congress enacted the "American Recovery and Reinvestment Act of 2009". This Act amended changes in the first-time home buyer credit. The maximum amount of the credit was increased to $8,000 ($4,000 for married filing separately individuals). Additionally, there is no recapture of the credit (i.e. no repayment of the credit required) in subsequent years. In other words, the interest-free loan was converted to financial assistance from the federal government. The taxpayer is required to purchase the property between January 1, 2009 and November 30, 2009. However, if the taxpayer claims the credit and sells the property within 3 years from the date of purchase then the recapture provisions apply according to IRC Sec. 36(f)(4)(D)(ii). A taxpayer can elect to treat realty purchased in the 2009 as realty purchased in 2008 under 36(g). In other words, if Ima purchased property in 2009, she can claim the credit on her 2008 individual tax return. Additionally, if the property was purchased in 2009, the taxpayer will not be subject to the repayment provisions. In both cases, the credit begins to phase out when the taxpayer's adjusted gross income exceeds $75,000 and completely phases out when the taxpayer's adjusted gross income exceeds $95,000 ($150,000 to $170,000 for joint filers) for the year of the purchase under Sec. 36(b)(2). 5 CONCLUSION There are several tax benefits available for taxpayers who purchase real estate, especially if used as their primary personal residence. As far as deductions, individuals can claim real estate taxes paid, mortgage interest paid, and home equity interest paid as itemized deductions. This benefits taxpayers whose aggregate itemized deductions exceed their standard deductions. However, interest expense deductions are subject to limitations on the principal balance. For individuals whose aggregate itemized deductions are less than their standard deduction an increased amount to the standard deduction is allowed for real estate taxes paid, subject to limitations. For first-time home buyers, there is a refundable credit available. Thus, if Ima purchases property she may be eligible to claimed itemized deductions and include mortgage interest and real estate taxes paid. Alternatively, if Ima does not have sufficient deductions to itemize she may increase her basic standard deduction for real estate taxes paid. This option is only available for 2008 and 2009. If Ms. Taxpayer purchases property in 2008 she may need to repay the credit. If Ima purchases the property in 2009, she does not have to repay the credit if she does not sell the property within three years. Therefore, it is advantageous for Ima to purchase property in 2009. Additionally, I am recommending that if she purchases property in 2009 that she reports the credit on her 2008 return in order to receive the credit sooner.