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Tax Strategies for Homeowners

Tracy Byrnes

Editor's note: As a special feature for March, TheStreet.com offers an ongoing series on everything you need to know about taxes. Today is part 11.

If we weren't talking about Britney Spears (and her disappearing panties) in 2006, we were talking about the housing market.

And it was quite stressful. If you were one of the 12 million buyers and sellers last year, you were probably worried about buying high and selling low, as well as about fluctuating interest rates and the ever-pending housing market crash.

And now, to make matters worse, you've got tax issues to deal with this April. But we're here to help. So let's walk through some of the housing matters you may face.

Thank Goodness, It's Sold

With housing prices slipping last year, those easy gains of 2005 were a mere memory. And many of you probably said novenas each night, hoping you wouldn't have to lower your price again. But hopefully you were still able to eke out some gain on that sale.

Now let's make sure you don't owe tax on it. The home sale exclusion rules say that you won't owe tax on any gain up to $250,000 for a single person and $500,000 for a married couple, presuming you lived there as your primary home for two of the past five years.

But as much as prices were falling, some sellers still made money. It was not out of the question for someone to have purchased a $1 million Manhattan apartment three years ago only to have flipped it for $1.3 million last year.

So now what? Well, using that example, the person gets the $250,000 freebie. He will then owe tax on the extra $50,000, and report it on Schedule D -- Capital Gains and Losses, just like a stock sale.

Big note: If you sold your place at a loss (and I'm sorry if you did), you can't claim a loss on your tax return for a house. Uncle Sam doesn't really care that the housing market took a turn for the worse in 2006.

Same goes for the sale of your vacation home. Sell it at a loss, and it's your problem. But if you sell it at a gain, Uncle Sam does the happy dance, because the gain from the sale of a second home does not qualify for the home-sale exclusion. You'll owe tax on the whole amount. So report it on Schedule D and pay the piper.

Here's a planning tip: If you still own a vacation home and are contemplating retirement soon, consider selling your principal residence and let the gain qualify for the exclusion. Then move into your vacation home. As long as you live there for at least two years, it will then become your principal residence, and that gain will qualify for the exclusion when you sell.

Now, if you sold your home or condo in the first few years after purchasing it, many mortgage companies charge an early prepayment penalty -- which is a joke, by the way. If you were forced to pay this ridiculous fee, be sure to mark it as a deductible on Schedule A -- Itemized Deductions.

And if you made any energy-efficient improvements in 2006 to get your home ready for its big sale, make sure you get credit for those upgrades on your tax return, says Bob Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal for tax professionals. Check out this previous story for more about which energy-efficient upgrades qualify.

It Was a Buyer's Market

It was the year of the buyer last year. Sellers were practically giving away their firstborn kids just to get the deal done. Fortunately, you don't have too much to worry about on your 2006 tax return if you bought your dream house (furnishing it is taxing enough!).

But what do you need to do is start keeping track of your basis in that new house. Remember, when you decide to sell (I know, the boxes aren't even unpacked), your gain is the difference between the selling price and the basis. So the higher your basis, the smaller your gain. And you need to keep that gain within the exclusion limits of $250,000 for singles and $500,000 for married couples to avoid a tax hit.

So tally your basis. Start with your purchase price and add your closing costs, including legal fees and costs for surveys and titles.

And don't forget about the mansion tax that some states impose. For instance, in New York, if the purchase price of the home is $1 million or more, the buyer must pay a "mansion tax" equal to 1% of the total price. Be sure to add that to your basis as well.

Then move on to any big improvements. If you decide to add a second level to a ranch later on, keep all that paperwork. If you update the kitchen, add on those costs. Same goes for new windows and updated bathrooms. So keep track. And check out IRS' Publication 936 -- Home Mortgage Interest Deduction for more details.

Speaking of updating that 1970s kitchen and the banana-yellow linoleum, if you decide to take out a home equity loan to remodel, there are a few mortgage rules you should know.

You can deduct the interest on home mortgage loans up to $1 million. So if your mortgage is $1.2 million, you can only deduct the interest on the first $1 million.

But the home equity world is different. Typically, you can only deduct interest on home equity loans up to $100,000. That's because many folks use home equity loans to buy cars, pay for college or finance that trip around the world.

The IRS has to set some limitation on pleasurable uses -- it doesn't want you having too much fun. But if you can prove that a loan is used strictly for home improvements, the $100,000 limit does not apply. In that case, your loan can max out at $1 million, and the interest will still be deductible.

Keep in mind that $1 million is an aggregate max. So while you can deduct the mortgage interest on a second home, that $1 million cap applies to both loans. Thankfully, your real estate tax deduction is unlimited. So if you pay taxes on two homes, deduct away.

Get Points for Refinancing

You may have paid points -- loan origination fees or discount points -- when you got your mortgage. Points are extra charges paid up front to get a lower interest rate on your mortgage. If you paid points in 2006, deduct them on your Schedule A.

On the flip side, if you paid points on a refinancing, they must be amortized over the life of the loan, says Scharin. So if you paid $3,000 in points on a 30-year loan, deduct $100 each year.

Let's say you refinanced a second time in 2006 (not out of the question). The points you were amortizing on the first refinance are now fully deductible. So deduct those and get rid of them, because the loan is gone. The points you paid on the newly refinanced loan must again be amortized.

With any mortgage, you should've gotten a Form 1098 -- Mortgage Interest Statement by the end of January showing the amount of deductible interest you paid on that loan in 2006. Form 1098 also reports any points paid in that year. But the form does not keep track of amortized points.

So make sure you explain to the IRS that you're deducting points from a prior year. Be sure to include a note to the back of your return showing how you calculated the amortized point deduction.

A Quick PMI Note for 2007

As a reminder, starting in 2007, you can now deduct your PMI or private mortgage insurance. When you put down less than 20% on the home you're purchasing, PMI is usually required to safeguard the bank that is loaning you the money. PMI is usually 0.5% of your loan balance each year, and you usually pay it monthly.

Well, starting in 2007, you can deduct that insurance amount along with your mortgage interest on Schedule A, says Scharin.

The PMI deduction phases out when the AGI of a married couple filing jointly hits $100,000 and then disappears when AGI hits $109,000. But still, for those who needed the insurance to get the mortgage in the first place, the deduction is a nice perk.

So take advantage of these housing perks, and enjoy your new home. Odds are good it'll become the money pit -- but hey, it's your money pit!

Next in the tax series: Deductions for Higher Education