Nondeductible Expenses

The acquisition of a home involves several additional costs over and above the purchase price. Unfortunately, many of these amounts are nondeductible or capital expenditures. In reviewing the settlement sheet, several big-ticket items are not deductible. For example, state and local transfer taxes are not deductible. The transfer tax is treated as part of the cost of acquiring the residence and is added to the property's basis (IRC Sec. 164). IRC Sec. 1001 provides a laundry list of nondeductible, capitalizable amounts incurred at settlement by the buyer. These items are part of the cost of acquiring the residence and increase the property's basis. Included among these capital expenditures are--

Amortization fees Abstracts of title Appraisal fees Brokerage fees Commissions Examining contract fees Examining title fees Geological surveys/opinions Legal fees Maps Miscellaneous Mortgage application fees Preparation of deed Promotion of sales Recording fees Title insurance Title opinions Transfer taxes

The settlement sheet may also include several nondeductible nor capitalizable expenses incurred or reimbursed by the buyer. Examples include water fees, trash collection fees, and condominium fees.

These rules also apply to refinancing an existing mortgage.

Deductible Expanses

However, the acquisition of a principal residence does provide a taxpayer with significant tax advantages. At settlement, home buyers often expend a significant amount of money on prepaid interest, mortgage interest, and real estate taxes to acquire the property.

Prepaid Interest. Under IRC Sec. 461(g,)(1), prepaid interest must be capitalized and deducted proportionately over the life of the loan. This rule applies to refinancing an existing home mortgage. However, an exception exists as to points paid on certain principal residence mortgages. Under the exception, cash-basis taxpayers can deduct the points in the year paid. A complete discussion of that exception, which was recently modified by Rev. Proc. 9427, is presented as a companion to this article.

Mortgage Interest. Subsequent to the acquisition of a home, most taxpayers initiate repayment of the loan. The monthly payment to the mortgage company may be comprised of several components. Only the interest on the mortgage and payments into an escrow fund for real estate taxes are deductible. The nondeductible component of the monthly payment includes repayment of principal, utility fees, FHA mortgage premiums, and escrowed amounts to purchase homeowner's insurance.

The mortgage interest paid annually by the homeowner to the mortgage company is reported to the homeowner and the IRS on Form 1098 (Mortgage Interest Statement). For loans made after 1990, the Form 1098 also shows the deductible points paid by the home buyer. Form 1098 is issued by a mortgage company when a homeowner pays $600 or more of mortgage interest in a calendar year. The homeowner should receive the form by January 31 every year. Mortgage interest expense and points are deductible on Form 1040, Schedule A.

Real Estate Taxes. In acquiring a residence, the real estate tax deduction is divided between the home buyer and the seller. Each party is entitled to a property tax deduction based on the number of days during the real property tax year that each party held title to the property. This rule applies regardless of the accounting method used and how the tax is actually apportioned between the parties IRC Sec. 164(d).

Normally, a buyer will reimburse a seller for taxes paid by the seller but deductible by the buyer. This reimbursement occurs at settlement and has no effect on the homeowner's basis of the property acquired IRC Sec. 1001(b)(1).

However, adjustments to the buyer's basis (and amount realized by the seller) can occur since the tax deduction is divided between buyer and seller regardless of who pays the tax. If the seller actually pays the taxes for the part of the year the buyer owned the home, the buyer must reduce the basis in the home by his share of the deductible taxes. Likewise, if the buyer paid tax for part of the year the seller owned the home, the buyer's basis would then be increased by the seller's share of those taxes IRC Sec. 1001 (b)(2).

The apportionment of real estate taxes is not a factor when refinancing a loan on a principal residence.

Real estate taxes paid at settlement and subsequent to settlement are deductible by the homeowner on Form 1040, Schedule A.

Thomas M. Brinker, Jr., JD, CPA, is associated with Saint Joseph's University and is a partner of Brinker, Simpson & Nicastro.