A homebuyer generally incurs various settlement and closing costs, such as title and attorneys’ fees, in connection with a residence purchase. These costs may be deductible, capitalizable (added to basis), or, in some cases, neither.
Deducting Real Estate Taxes
Real estate taxes are taxes imposed on interests in real property (Regs. Sec. 1.164-3(b)). Rev. Rul. 80-121 provides that the tax must (1) be generally imposed or triggered by the ownership of real property and not the incidents of property ownership such as use or disposition, (2) be measured by the value of real property, and (3) not solely be a personal liability of the owner. Similarly, real estate taxes do not include special assessments for capital improvements such as sidewalks, streets, or similar improvements (Regs. Sec. 1.164-4). The taxpayer can only add these assessments to the tax basis of the home.
Questions arise as to who is considered the owner of real property when a lease-option agreement is involved. These questions center on whether the lease-option agreement constitutes an actual purchase of the property or a mere option to purchase. State law determines whether there is considered to be an actual transfer of legal title (i.e., a purchase). Absent such a transfer, it must be determined (under state law) whether there is a practical assumption of the benefits and burdens of ownership. The equitable or beneficial owner of real property who pays the real estate taxes imposed on such property may deduct them even though another person holds the legal title.
In a case involving a lease-option agreement, the Tax Court examined the facts and concluded that even though the lessee had exclusive use of the property, various benefits and burdens of ownership remained with the lessor (i.e., payment of insurance premiums and authority to make key decisions on maintenance and improvements to the property, etc.); therefore the taxpayer/lessee failed to prove that he obtained equitable ownership of the property and could not deduct the real estate taxes associated with it that he had paid (Jones, T.C. Memo. 2006-176).
The purchaser can deduct real estate taxes as an itemized deduction for the portion of the property tax year he owned the home, whether the buyer or seller actually paid the tax. In the year a property is sold, property taxes must be apportioned between the buyer and seller based on the number of days each held the property during the real property tax year (Sec. 164(d)).
Caution: Real estate taxes are not apportioned if delinquent taxes are owed at the time of sale (Regs. Sec. 1.164-6(b)(2)). If the buyer pays the delinquent taxes, they are added to the buyer’s basis in the property (Riordan, T.C. Memo. 1978-194).
Normally, property taxes are paid by either the seller or buyer, depending on when the taxes are due. Then, at closing, the nonpaying party reimburses the paying party for his pro rata share of the taxes based on the property tax year. Cash-basis sellers or buyers deduct their share of apportioned real estate taxes in the year they are deemed to have paid them. The proration of taxes is normally shown on the closing statement for the sale.
Example 1: F and C purchased their home on Sept. 1, 2012. The property tax year is the calendar year, and the tax is payable on Aug. 1. The seller paid 2012 taxes of $5,300 on Aug. 1, 2012. F and C’s settlement costs paid at closing included $1,767 [(122 ÷ 366) × $5,300] representing their share of the 2012 taxes (prorated, based on Sept. 1 acquisition).
F and C can deduct their share of the 2012 taxes ($1,767) in 2012. The seller can also deduct her share of the 2012 taxes in 2012. Although her year-end mortgage statement will show $5,300 of taxes paid, the seller must reduce this amount by the $1,767 apportioned to F and C and shown on the closing statement for the sale of the house. This results in a Schedule A deduction of $3,533 ($5,300 – $1,767) for the seller.
If property taxes for the entire year are paid by the buyer after the date of sale, the seller is generally treated as if he or she paid his or her share of the taxes on the date of sale. The buyer deducts his or her pro rata share of the taxes as of the date the taxes are actually paid (Regs. Sec. 1.164-6(d)).
Example 2: Assume now that the 2012 taxes are payable under local law on Jan. 31, 2013, and F and C paid $5,300 on that date. They can still deduct their $1,767 share of the 2012 taxes, but not until 2013, the year in which the taxes were actually paid. (The seller is treated as though she paid her share of the 2012 taxes on the date of sale.)
Deducting Mortgage Loan Points
In general, Sec. 461(g) requires prepaid interest (which includes mortgage loan points) to be amortized and deducted over the life of the loan using some reasonable method (e.g., straight-line or in proportion to principal payments). However, Sec. 461(g)(2) provides an exception that allows cash-basis taxpayers to deduct prepaid points upon payment if:
The points are paid on indebtedness incurred in connection with the purchase, construction, or improvement of a principal residence; and
The indebtedness is secured by the principal residence, the charging of points is an established business practice in the area, and the points charged do not exceed the amount charged in the area.
For this purpose, points include amounts (1) designated as such on a closing statement (and are referred to as either loan origination fees, loan discount, discount points, or points); (2) computed as a percentage of the loan amount; and (3) charged under the established business practice of the area in which the residence is located (Rev. Proc. 94-27). Amounts designated as points in lieu of amounts normally separately stated on the closing statement (e.g., appraisal fees, inspection fees, attorneys’ fees, or title fees) are not deductible as points.
Points are currently deductible under Sec. 461(g) even if the principal residence is also used (either partially or substantially) for rental purposes (Russell, T.C. Memo. 1994-96, aff’d, 76 F.3d 388 (9th Cir. 1995)).
Caution: Only points paid in connection with the purchase, construction, or improvement of a principal residence qualify for a deduction when paid. Points paid for a second (vacation) home or with a mortgage refinancing of the original principal residence loan are not deductible when paid (Rev. Rul. 87-22; Rev. Proc. 87-15). The taxpayer must capitalize the points and amortize them over the term of the loan.
Under Rev. Proc. 94-27, points paid in connection with the purchase of a principal residence do not have to be paid from the taxpayer’s separate funds (i.e., funds other than loan proceeds) to be currently deductible. Instead, taxpayers are deemed to have paid the points directly to the extent of (1) down payments; (2) escrow deposits; (3) earnest money applied at closing; and (4) other amounts actually paid at closing. This is a departure from the former rule that points must be paid directly from separate funds to be deductible under Sec. 461(g). However, the separate fund rule apparently still applies to points paid in connection with a loan for the improvement of a principal residence.
Rev. Proc. 94-27 also addresses seller-paid points. Buyers are treated as having paid seller-paid points if they reduce their basis in the residence by the amount of those points. This means the buyer can currently deduct seller-paid points if the other rules for a current deduction are satisfied. If the buyer does not adjust basis, no deduction is allowed.
Capitalizing Other Purchase Costs and Fees
In addition to points, mortgage lenders usually charge the borrower a variety of fees for obtaining the loan. These fees are not deductible. The borrower may also incur attorney, appraisal, and title fees in connection with the purchase of a home. These types of expenditures are added to the property’s basis (Temp. Regs. Sec. 1.263(a)-2T). In addition, other incidental expenses associated with a home purchase, such as recording fees and transfer taxes, are added to the basis of the home.
Planning tip: The buyer should keep track of all expenditures that he or she can add to basis since they may provide a tax benefit on a subsequent sale of the property. Often records of costs associated with a home purchase and subsequent improvements are lost over the years, causing the taxpayer to understate the basis of the residence when it is sold. This leads to an overstated gain on the sale. With the $250,000 ($500,000 if married filing jointly) gain exclusion, this may be less of an issue. However, if a taxpayer converts a home to rental, investment, or office use; has a gain in excess of the dollar limitation under the exclusion provisions; or sells more than one home within a two-year period, basis records will be needed to verify tax basis for reporting the proper gain in a future sale of the residence.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 13th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.