New Federal Housing Act Contains Important Tax Provisions

In July of 2008, Congress passed, and the President (reluctantly) signed into law The American Housing Rescue and Foreclosure Prevention Act of 2008, shortened by everyone to "The Housing Act". The new legislation, passed in response to repeated bad news from the housing sector of the U.S. economy, contains tightened regulations for financial institutions, especially those that are engaged in mortgage lending, block grants to enable state and local governments to buy up foreclosed homes to protect the neighborhoods where they are located, and the promise of emergency assistance to the quasi-governmental mortgage giants Fannie Mae and Freddie Mac. It was the block grants that gave The President heart-burn, but he finally gave in to what looked like a pretty certain override of his threatened veto, and signed the bill into law on July 30.

There are also some income tax measures included, and at least three of these would appear to have wide-spread impact for taxpayers. The provisions discussed in this article are:

  • A first-time homebuyer tax credit (36 of the Code). Don't assume that you don't qualify for this one just because you have owned a home at some time in the past, and don't assume that it is a credit. It is actually an interest-free loan from the U.S. government.
  • A property tax deduction for non-itemizers (63(c)). This is an addition to the standard deduction that allows taxpayers to deduct some or all of their real property tax expense even if they don't itemize deductions on their return; and
  • A revenue raising provision that modifies the exclusion of gain on the sale of principal residence (121(b)(4)). It will cause gain allocable to non-qualifying use of the residence to be taxed without regard to the exclusion.
It is important for Alabama taxpayers to note that these are federal tax provisions, and the first two changes mentioned will not apply to Alabama taxes without specific legislative action. However, it does appear that the limited gain recognition on some sales of a principal residence will apply to Alabama tax returns also. The federal provision is an amendment to Internal Revenue Code 121, and Alabama Code 40-18-14(3)i adopts 121 by reference.

The First-Time Homebuyer Credit

Allowance of the Credit

If an individual buys a home for use as her principal residence between the dates of April 9, 2008 and June 30, 2009, and she acquired the property by purchase from an unrelated party, she may be eligible for the new First-Time Homebuyer Credit. The amount of the credit is the lesser of (1) 10% of the cost of the home, or (2) $7,500 ($3,750 for a married person filing a separate return). The credit is a dollar-for-dollar reduction of both regular tax and Alternative Miniumum Tax (AMT), generally in the year of the purchase. However, there is an election discussed below to treat a 2009 purchase as having taken place in 2008.

To be eligible for the credit, both the taxpayer and her spouse, if she is married, must meet the definition of a "first-time homebuyer". This term is misleading, since the definition is that the individual has not had an ownership interest in his or her principal residence at any time in the three years prior to the credit-eligible purchase. The term "principal residence" is defined by reference to Internal Revenue Code (IRC) 121, which deals with the exclusion of gain on the sale of a principal residence. The Code itself does not attempt to define the term, but based on the case law and regulations, it would seem that the general rule is that your principal residence is the place where you spend the majority of the time away from work. Other factors, such as whether you claim a homestead exemption for property taxes, the mailing address you use for official correspondence, and the address on your drivers license, are also considered. A vacation home is not a principal residence, and it is possible for a houseboat, trailer, co-op, or condominium to be a principal residence.

An unrelated party, obviously, is someone who is not related to you, and relationships are determined by reference to 267 and 707. In general, your related parties for purposes of 36 are yourself, your spouse, your and your spouse's lineal ancestors and lineal descendants, your and your spouse's siblings, and any entities where members of that group own a controlling interest, either directly, or by attribution. The attribution rules are highly technical, and far-reaching. For example, stock in a corporation owned by a parent is "attributed" to his children, and stock owned by spouses is attributed to the other spouse. This means that if you buy a home from a corporation owned by your son's wife's father, you could be buying from a related party. If there is any doubt at all about this issue, you should consult a tax professional and ask him or her to parse through these rules with your fact pattern in mind.

The credit amount is reduced ratably to zero between certain levels of Modified Adjusted Gross Income (MAGI). The MAGI phaseout levels are between $150,000 and $170,000 for a married couple filing a joint return, and $75,000 and $95,000 for all other taxpayers. Modified Adjusted Gross Income is the Adjusted Gross Income computed on the tax return, plus any income that was excluded as

  • Foreign earned income under 911,
  • Income from American Samoa under 931, or
  • Income from Puerto Rico under 933.

Example 1: Bill and his two sisters jointly own a vacation home at Orange Beach, but his principal residence has always been a rented apartment. If Bill purchases a home between April 9, 2008 and June 30, 2009 to be used as his principal residence, he could qualify for the credit, subject to the MAGI limitations, since he has not had an ownership interest in his principal residence in the last three years.

Example 2: Sarah owned her principal residence until June 30, 2005, when she moved to a rented apartment. If Sarah purchases a home between July 1, 2008 (three years and one day after she last owned a principal residence) and June 30, 2009, she could qualify for the credit, subject to the MAGI limits.

Example 3: John and Mary, a married couple, buy a home from John's father that will be used as their principal residence. John and Mary do not qualify for the credit, because they did not purchase the home from an unrelated party.

Example 4: Same facts as in Example 3, except that John and Mary inherit the home from a deceased older neighbor that Mary had befriended. Their inheritance of the home is not considered to be a purchase, so it does not qualify for the credit.

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Recapture of the Credit

This particular "credit" is really a loan, one that must be repaid over 15 years, although without interest. If you claim the credit in 2008, you must begin paying it back in 2010 by adding 1/15 of the credit to your tax liability on your 2010 tax return. You will continue to make this addition to your tax bill each year until the credit is fully repaid in 2024.

If you sell the home before you have repaid all of the credit, the unpaid amount (also referred to as "unrecaptured amount") must be added to your tax in the year of the sale. If the sale is to an unrelated party, however, you only need to repay the unrecaptured amount to the extent of the gain, if any, on the sale. For purposes of determining gain, the cost basis of your home is reduced by the unrecaptured credit. (See Example 7 below.)

Example 5: Mike and Jane, a married couple filing a joint tax return, neither of whom has had an ownership interest in a principal residence in more than three years, have a combined MAGI of $135,000 in 2008. On October 1, 2008, they purchase a principal residence for $200,000. They qualify for a First-Time Homebuyer's Credit of $7,500 on their 2008 return (the lesser of (a)10% of the cost of the home - $20,000, or (b)$7,500). Assuming that they continue to live in the home for at least 17 years, they will add $500 (1/15 of $7,500) to their tax liability for the 2010 tax year, and they will make the same addition for each subsequent year through 2024.

Example 6: Assume the same facts as in Example 5, except that in early 2012, after Mike and Jane have recaptured $1,000 of the credit, they sell the home to Jane's parents for $190,000. On their 2012 tax return, Mike and Jane will have an addition to their tax liability of $6,500 (Total credit of $7,500 less $1,000 recaptured in 2010 and 2011). The limitation of the recapture to the amount of the gain doesn't apply in this case, since they sold the home to a related party.

Example 7: Assume the same facts as in Example 5, except that in 2012, Mike and Jane sell the home to an unrelated party for $198,000. They will have an addition to their 2012 tax of $4,500 for recapture of the credit as calculated in the illustration below. Mike and Jane will never have to repay the remaining $2,000 of the credit ($7,500 less $1,000 in 2010 and 2011, less $4,500 in 2012).

recap with gain

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Election To Treat 2009 Purchases As Having Occurred In 2008

In general, you will claim the credit on your tax return for the year in which you purchase the residence, but 36(g) allows you to elect to treat purchases in 2009 as having occurred in 2008, so you would then be able to take the credit on your 2008 return. If you have already filed your 2008 return when you buy the home, you can amend the return to include the credit, so you will not have to wait until you file your 2009 return to get the benefit. Another factor that you will want to consider is your MAGI levels in the two years. It appears that if you do elect under 36(g), it will be your 2008 MAGI that is considered, even though the purchase is in 2009. If you expect an income boost in 2009 that might push you past the phase-out point for the credit, you probably would want to make the election so your lower 2008 MAGI would apply. Remember, real life fact patterns are more complicated than any illustration in a tax article, so you should always confer with an income tax professional before making decisions of this nature.

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Property Tax Deduction For Non-Itemizers

Before the Housing Act added 63(c) to the Code, property taxes on real property were deductible, but as an itemized deduction. Only those persons who had net itemized deductions, after applying all the relevant limitations, that were greater than their Standard Deduction realized any tax benefit from the payment of these taxes. Furthermore, because taxes are not deductible for Alternative Minimum Tax (AMT), even itemizers might not have any real reduction in their tax liability from the payment of property taxes. Now, for tax years beginning in 2008 only, everyone who pays state and local real property taxes will get a regular tax (but not AMT) benefit from those taxes paid, regardless of whether they itemize deductions or not.

Here's how it works. You can still deduct your real property taxes as an itemized deduction. That hasn't changed. In addition, only for tax years beginning in 2008, the Standard Deduction includes a "Real Property Tax Deduction" (RPTD) component. The RPTD is the state and local real property taxes that are otherwise allowable as an itemized deduction, but limited to a maximum of $1,000 for married couples filing a joint return, and $500 for all other taxpayers. On your 2008 tax return, you will either deduct a Standard Deduction, or you will deduct your net itemized deductions, whichever is greater. Both of them will include at least a portion of your real property taxes paid.

Taxes paid on a second home should be included in the RPTD, subject to the overall $1,000 or $500 limitation. Foreign real property taxes can be deducted as an itemized deduction, but it appears that such taxes will not be included in the RPTD. Given Alabama's extremely low property tax rates (hence our chronic under-funding of public education), the $1,000 limit will affect a much smaller percentage of Alabama taxpayers than it will in most other states. The great majority of Alabama families don't pay as much as $1,000 per year in real property taxes. Finally, the Standard Deduction is not allowed for purposes of the AMT, so if you are subject to the AMT in 2008, the RPTD won't help you.

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No Exclusion Of Gain Allocable To Non-Qualifying Use Of Residence

Prior to the passage of the Housing Act, if you sold your principal residence at a gain, you did not have to pay tax on that gain if the gain did not exceed $250,000 ($500,000 for married couples filing a joint return). In order to qualify for this exclusion of the gain, you must have used the property as your principal residence for at least two years out of the five years immediately prior to the sale. You were entitled to the full exclusion even if you had used your home at some point while you owned it as a rental property, or a vacation home (non-qualifying use). The only exception was that if you had claimed any depreciation expense on the home after May 6, 1997, any gain on the sale, to the extent of the depreciation claimed, had to be reported and included in taxable income.

New 121(b)(4), added by the Housing Act, provides that for sales of principal residences after December 31, 2008, any gain allocable to periods of non-qualifying use will not qualify for the overall exclusion of gain. Periods of non-qualifying use are any periods after December 31, 2008 during which the taxpayer owns the residence, but it is not being used as his principal residence. In other words, non-qualifying use prior to January 1, 2009 is not considered. Also, there are certain situations where even though the home is not being used as the principal residence, its use during that period does not cause additional gain to be recognized. Periods that will not be considered "periods of non-qualifying use" are:

  • Use during any portion of the five-year period immediately prior to the sale of the residence after the two-year or more use as a principal residence by the taxpayer.
  • Any use during a period not to exceed 10 years that the taxpayer or spouse is serving on "qualified official extended duty" (generally overseas assignments with the uniformed services, the U.S. State Department, or U.S. intelligence services such as the CIA); and
  • Any use during a period, not to exceed two years, of temporary absence due to job requirements, health conditions, or some other unforeseen circumstances.

Before you allocate the gain to periods of non-qualifying use, you must first reduce the overall gain by any amounts that are not excluded by virtue of depreciation expense claimed after May 6, 1997. Then, you will compute a fraction, the numerator of which is the aggregate periods of non-qualifying use, measured in months or days as appropriate, and the denominator is the total time you owned the home, including ownership prior to January 1, 2009. The result of this fraction is applied to the total gain remaining after recapture of depreciation, and that portion of the gain is not eligible for the exclusion.

Example 8: Will and Martha, a married couple filing a joint return, bought their home for $175,000 on January 1, 2008. From January 1, 2009 through June 30, 2009, they took an extended trip around the world, and temporarily rented their home. In conjunction with that rental, they claimed depreciation deductions in 2009 of $1,000. They sold the residence on July 1, 2011 for $250,000. They have used the home as their principal residence for the entire time they have owned it, except for the temporary rental period of six months in 2009. As shown in the illustration below, Will and Martha have total gain on the sale of their residence of $75,000, of which $1,000 is taxable as depreciation recapture, $10,582 is taxable because it is allocable to periods of non-qualifying use, and the remaining $63,418 will be excluded by 121.

121(d) gain

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This page last updated 8/17/08