While many of the non-tax provisions of the Housing and Economic Recovery Act of 2008, enacted on July 30, 2008, appear directly focused at the problems arising from the housing and mortgage crisis that has developed over the last year, the tax provisions appear at best to have only an indirect effect on the individuals most impacted by the subprime mortgages and declining home values.The tax title to the legislation includes many provisions focused on the low-income housing credit, housing and mortgage bonds, and real estate investment trusts. This column, however, will take a closer look at some of the individual tax breaks and revenue raisers most likely to impact individual taxpayers and their tax returns in 2008 and coming years.
While part of the problem that got us into the current crisis was lending to people who perhaps did not have the means to be buying homes in the first place and to pay back the debt, Congress has decided that the government should get into the business of lending to low-income homeowners as well. Structured as a refundable credit, the first-time homebuyer credit gives first-time homebuyers a temporary refundable credit equal to 10 percent of the purchase price of a home, up to $7,500 ($3,750 for married individuals filing separately).
The credit is refundable, so lower-income taxpayers who do not owe income taxes can still get a check from the government up to $7,500. The credit phases out at adjusted gross income levels of between $75,000 and $95,000 for single filers and $150,000 to $170,000 for joint filers.
The most unique feature of the credit, however, is that it must be repaid to the government over a 15-year period, interest free, starting in the second year after purchase. Now, an interest-free loan sounds pretty good, but this seems a lot like the 100 percent financing of home purchases for lower-income taxpayers with no credit checks that helped to get us into trouble in the first place. Will taxpayers receiving a refundable credit of $7,500 be able to repay that sum over the next 17 years? Or, as with the record number of foreclosure actions, will the Internal Revenue Service have a record number of collection actions? Will these debts to the government offset payments of the refundable earned income tax credit and child tax credit designed to provide some cash to low-income taxpayers, particularly those with children?
WHO WAS THIS CREDIT DESIGNED TO HELP?
A first-time homebuyer is defined as someone who has not had an ownership interest in a principal residence for the last three years prior to the purchase of the home in question. The credit is not, therefore, designed to help people who bought or owned a home in the last three years and are losing it through foreclosure. The credit is designed to help the housing industry reduce the inventory of unsold homes by luring even more people into home ownership.
The credit is effective for homes purchased on or after April 9, 2008, and before July 1, 2009. An election is available to claim the credit in 2008 for a home purchased in the first half of 2009. The election option would come the closest to making the funds available as close to the closing date as possible, but under no circumstances does it appear that the credit would make funds available at closing. An industry is likely to develop to advance these funds to homebuyers at closing, with interest, and with a security interest in the refundable credit when the taxpayer receives it. This is likely to benefit the lending industry as much or more than the homebuyer.
Those taxpayers who qualify should probably look at the credit as an interest-free loan and nothing more. They should carefully assess their ability to repay the loan on time. Taxpayers for whom the credit is essential to buying a home should weigh carefully whether they would be overextending themselves. Once a payment is missed on the repayment of the interest-free loan, it appears that normal interest and penalties associated with failure to pay tax when due would start to accumulate. Taxpayers should also keep in mind that the repayments are accelerated on the sale of the home, and they are forgiven on the death of the taxpayer.
REAL ESTATE TAX DEDUCTIONS
While the Tax Code has for many years had additional standard deductions for people over age 65 and people who are blind, the housing legislation introduces for the first time an additional standard deduction for an item that is a component of itemized deductions — state and local real estate taxes. The additional standard deduction is the amount of the lesser of the amount of real property taxes paid during the year or $500 ($1,000 for joint filers). The provision is only effective for 2008.
Why not just raise the standard deduction by $500? Such an approach would have been a plus for simplicity but would probably have come with additional cost because it was not sufficiently “targeted.”
So, who does this tax break benefit? It does not benefit your typical homeowner if the typical homeowner has enough mortgage interest and state taxes to itemize, rather than take the standard deduction. However, IRS statistics indicate that a lot of homeowners may be taking the standard deduction. Home ownership in the U.S. is approximately 70 percent, yet only about 36 percent of individual taxpayers itemized their deductions in 2005.
Some of these may be taxpayers who would be better off itemizing but prefer the simplicity of the standard deduction. Others may be owners of lower-priced housing where the interest and taxes are too small to exceed the standard deduction. Others may be older Americans who have paid off their mortgages and, without mortgage interest, are better off with the standard deduction. Others may be healthy, stingy, wealthy people who pay cash for their homes and do not have enough medical expenses or charitable contributions to itemize.
Each of these categories could benefit from the additional standard deduction. It is not clear which categories Congress had in mind to help.
HOME SALE EXCLUSION
The addition to the Tax Code in 1997 of the home sale exclusion to replace the old carryover rules probably added simplicity to the code but substituted one set of Tax Code-motivated behaviors for another. Under the old rules, the motto was always trade up so the proceeds of one sale were always fully invested in the next purchase so that no gain was realized. The motto under the new rule was always make a property your principal residence for at least two years prior to sale to qualify for the maximum exclusion.
A revenue raiser in the housing legislation attacks this strategy head-on. After Jan. 1, 2009, any period of non-qualified use, i.e., use other than as a principal residence, goes into a formula to allocate a portion of the gain on the sale as not qualifying for the exclusion. The ratio is the period of nonqualified use to the total period of ownership of the property.
While the provision does directly attack the practice of moving from one residence to another that the taxpayer previously owned as a vacation or rental property, hypothetically every two years, and claiming a full exclusion on all years of appreciation, the new rules do preserve some opportunities.
First, the taxpayer is not penalized for any use prior to Jan. 1, 2009. The tax effect of the new provision will therefore be somewhat gradual. A taxpayer who has rented out a property for 30 years (or owned it as a vacation home) can still move into it on Jan. 1, 2009, sell it after two years, and qualify all the gain for the full exclusion. The same taxpayer who moves into the property on Jan. 1, 2010, and sells it after two years still would only have 1/33rd of the gain not qualify for exclusion. Of course, as under prior law, any gain associated with recaptured depreciation after May 6, 1997, is subject to tax at a 25 percent rate.
Second, the taxpayer is not penalized for use of the property as other than a principal residence after use as a principal residence within the five-year test period. In other words, if a taxpayer meets the two-out-of-five-year ownership-and-use test and the period of ownership and use precedes the period of vacation or rental use (or just sitting on the market waiting to be sold), the taxpayer still qualifies for the full exclusion.
Third, the taxpayer is not penalized for temporary absences from the principal residence for periods of less than two years due to employment, health or unforeseen circumstances.
Fourth, the extended qualification periods available to the military, the foreign service, the intelligence community, and Peace Corps volunteers would still be available.
Finally, the tax law was changed a few years back to require a five-year ownership-and-use test to qualify for the full exclusion for like-kind exchange property. It is not clear how the new law changes relate to the like-kind exchange rule. It may be that rental property could be exchanged for other rental property after Jan. 1, 2009, and, as long as the new property is immediately converted to a principal residence and used as such for five years, the full exclusion would be available. It is also possible that the IRS could read into the carryover-of-basis requirement a carryover of the nonqualified use of the old property to the new property.
With adequate planning and additional patience, taxpayers should be able in many cases to make significant end-runs around these new restrictions.
Another revenue raiser included in the housing legislation requires banks and other processors of merchant payment card transactions, including credit and debit cards, to report to the IRS the annual gross payment card receipts with respect to a particular merchant. This would also affect online transactions, such as those involving Ebay and PayPal.
Some taxpayers have expressed concern that this would give the IRS detailed information on the transactions of individual taxpayers. Assuming that the reporting is only done on a gross transaction basis for any particular merchant — and that is all that the law requires — there should not be a lot of privacy concerns with respect to individual transactions. The new law would give the IRS a better tool to detect underreporting by business entities accepting credit and debit card transactions.
The new housing law introduces some novel concepts in its tax provisions, with a refundable and recapturable tax credit and an additional standard deduction for a specific component of the itemized deductions. To pay for these tax breaks, Congress also took away some of the flexibility available with the exclusion on sale of a principal residence.
While these provisions raise some interesting issues with respect to how to benefit from the tax breaks or how to avoid the revenue raisers, they seem at best only tangentially related to addressing the problems arising from the housing and mortgage crisis.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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