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Tax
Aspects of Mortgage Refinancing
 With
the proliferation of mortgage financings in recent years, it is important
to understand the rules relating to tax deductions allowed in connection
with the refinancing. Interest that you pay on a home mortgage is
deductible within limits, depending on whether it is home acquisition debt,
home equity debt, or grandfathered debt. Interest on the refinanced
mortgage will be deductible if it falls within one of these categories.
Home acquisition debt is a debt taken out
after Oct. 13, 1987, to buy, build, or substantially improve your main or
second home, and that is secured by that home. Interest on home acquisition
debt is deductible, but only to the extent that the debt does not exceed $1
million ($500,000 if married filing separately). Home equity debt is any
debt secured by your first or second home, other than home acquisition debt
or grandfathered debt. Thus, it includes mortgage loans taken out for
reasons other than to buy, build or substantially improve your home, and
mortgage debt in excess of the home acqusition debt limit ($1M). Interest is
deductible on up to $100,000 of home equity debt ($50K if married filing
separately). Grandfathered debt is mortgage debt secured by your first or
second home that was taken out prior to Oct. 14, 1987, no matter how you
use the proceeds. All of the interest paid on grandfathered debt is fully
deductible.
When refinancing, if the old mortgage that
you are refinancing is home acquisition debt , your new mortgage will also
be home acquisition debt, but only up to the principal balance of the old
mortgage just before it was refinanced. The interest on this portion of the
new mortgage will be deductible. Any debt in excess of this limit won't be
home acquisition debt, although it may qualify as home equity debt, subject
to the $100,000/$50,000 limit. Most taxpayers are unaware that these limits
exist when it comes to refinancings--they either assume, or are incorrectly
told by their mortgage representative, that all of the interest on such
debt is tax deductible. If you are refinancing grandfathered (pre-Oct. 14,
1987) debt for an amount that isn't more than the remaining debt
prinicipal, the remaining debt will still be grandfathered debt.
In general, points that you pay to refinance
your home are not fully deductible in the year that you paid them. Instead,
you can deduct a portion of the points each year over the life of the loan.
However, you may be entitled to a larger first-year deduction if you used
part of the proceeds of the refinancing to improve your home and you meet
other requirements. In that case, the points associated with the home
improvements may be fully deductible in the year paid. If you are
refinancing your mortgage for the second time, the portion of the points on
the first refinanced mortgage that you haven't yet deducted may be deductible
in full at the time of the second refinancing. Clearly, you need to take
many of these rules into consideration before you decide to whether it is
economically prudent to refinance your mortgage.
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Greetings!
We would
like to welcome the many new subscribers and newsletter recipients to
this month's issue. If there is ever a topic that you would like
discussed in a future issue, please do not hesitate to tell us.
This month's issue includes a discussion on two topics
that should be of interest to most individual taxpayers and two new tax
act provisions that will be helpful to select taxpayers.
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· Minors' Trust
vs. Custodial Account
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 When one considers
making large cash gifts to young children, delaying the child's ability
to access such funds should certainly be a factor in how this is
accomplished. Of course, you will also want the gifts to be gift-tax
free, that is, qualify for the gift tax exclusion. This allows you and
your spouse to give up to $22,000 a year to each child gift-tax free.
This creates a problem since the annual exclusion is available only for
gifts of so-called "present interests". By restricting the
children's ability to access the gift, the transfer may not be tax free.
With some planning, however, there are ways to accomplish both goals.
One such
strategy is a "minor's trust" (known formally as a
"2503(c) trust"). Contributions to this type of trust can qualify
for the annual gift tax exclusion if the property and its income may be
used by or for the benefit of the child before age 21, and the remainder
will go to the child when he or she reaches age 21. These trusts are
frequently used when substantial funds are transferred to a minor either
all at once, or year after year using the annual gift tax exclusion.
Unlike simple custodial accounts, a trust offers the opportunity to
customize its terms to meet specific needs. Nevertheless, holding assets
in a trust may subject them to a compressed income tax bracket each year
and, therefore, a potentially greater tax liability. Instead of the
income in this trust being taxed at the broad tax bracket ranges
applicable to individuals (whether under the parents' rate under the
Kiddie Tax rules or at the child's own rates as a single taxpayer), the
rate brackets for trusts climb very quickly. Gifts to custodial accounts
under the UGMA or UTMA rules also qualify for the annual gift tax
exclusion, even though the custodian manages the property until it must
be turned over to the child when he or she is no longer a minor. Income
from custodial accounts avoids the compressed income tax brackets that
apply to trusts. Instead, the income is taxed directly to the child. If the
child is under age 14, the income may be subject to the Kiddie Tax, which
taxes the child's income at the parent's marginal rate. However, there
are many techniques for avoiding that tax, such as placing growth stock
into a custodianship, or giving the child EE bonds. By waiting to sell
the stock or cashing in the bonds until the child is 14 or older. the
kiddie tax is avoided. Before deciding between a minors' trust and a
custodianship, there are many tax and non-tax factors to consider,
including the formalities and administrative costs associated with a
trust and the flexibility associated with a custodianship.
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· New Rules for
Deducting Attorney Fees
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There is a split of authority on whether contingent
attorney's fees paid directly to attorneys out of a taxable judgment or
settlement (i.e., for a nonphysical injury, such as unlawful
discrimination) are excludible from the taxpayer's gross income or are
includible in income but potentially deductible as an expense. The US
Supreme Court has agreed to decide this issue. Under pre-2004 Jobs Act
law, where a judgment or settlement was non-business income or related to
a taxpayer's employment, the attorney's fees were miscellaneous itemized
deductions, subject to the 2% - of-AGI floor on such deductions and to
the overall limitation on itemized deductions. Further, such fees were
not deductible at all for alternative minimum tax purposes.
Under the
new 2004 tax law, an "above-the-line" tax deduction (i.e. a
deduction taken from gross income in arriving at adjusted gross income)
is allowed for any deductible attorney fees and court costs paid by, or
on behalf of, the taxpayer in connection with an action involving: (1) a
claim of unlawful discrimination or (2) a claim made under a private
cause of action under the Medicare Secondary Payer statute. As a result,
the above-the-line deduction applies whether or not eligible legal fees
are paid on a contingency basis; the provision does not add new
deductions, but, critically important to the issue, it allows amounts
that were already deductible to avoid the limitations applied to
miscellaneous itemized deductions; such legal expenses are allowed to be
deducted for alternative minimum tax purposes since they are no longer
treated as miscellaneous itmeized deductions; the reduction in adjusted
gross income from this new above-the-line deduction may have a positive
impact on other items on the taxpayer's return, such as personal
exemptions, medical deductions, casualty losses and other items that may
be limited based on one's AGI. This new law only applies to fees and
costs paid after October 22, 2004, with respect to any judgment or
settlement occurring after that date. For amounts paid prior to that
date, taxpayers will have to wait for the Supreme Court to rule on the
issue. Of course, legal fees that are ordinary and necessary expenses of
the taxpayer's business and are reasonable in amount are deductible as
business expenses.
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· New Rules for
Sales Tax Deductions
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For tax years beginning in 2004 and 2005, the new Tax Act
allows taxpayers to elect to take state and local general sales and use
taxes as an itemized deduction instead of taking an itemized deduction
for state and local income taxes. Taxpayers who live in a state that does
not impose income taxes (Alaska, Florida, Nevada, South Dakota, Texas,
Washington and Wyoming) will prosper under this new provision. Further,
those taxpayers who live in a state that imposes both income taxes and
sales taxes may be positively affected, depending the amount of each.
Taxpayers
who make this election may either deduct their actual sales taxes or use
an IRS-published table and then add to the amount from those tables the
actual amount of their sales tax for motor vehicles, boats, and other
specified items. The IRS is to publish tables based on the average
consumption by taxpayers, on a state-by-state basis, of items other than
autos, boats, etc. This new deduction affects year-end tax planning--even
in those states with an income tax, taxpayers should determine whether
sales taxes for a particular year will exceed their state/local income
taxes-one may wish to bunch major purchases into the same year so that
the sales tax amount for that year will exceed the income tax deduction.
By doing this, one can deduct their sales taxes in one year and their
income taxes in another year, especially if they decide to defer any
year-end state estimated tax payments to the following year.
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