Tax aspects of refinancing a home mortgage

You are planning to refinance the mortgage on your home and have asked me about the tax rules regarding the refinancing. This letter will discuss whether you can deduct the interest you will pay on your new mortgage, the points that you pay, and other fees that you may pay in connection with the refinancing.

Interest deduction. 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 into one of these categories, as explained below.

Home acquisition debt is a mortgage you took 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 your total home acquisition debt can't 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 acquisition debt limit. Interest is deductible on up to $100,000 of home equity debt ($50,000 if married filing separately).

Grandfathered debt is mortgage debt secured by your first or second home that was taken out before Oct. 14, 1987, no matter how you used the proceeds. All of the interest you pay on grandfathered debt is fully deductible.

Refinancing. If the old mortgage that you are refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, 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, but it may qualify as home equity debt, subject to the $100,000/$50,000 limit.

If you are refinancing grandfathered (pre-Oct. 14, 1987) debt for an amount that isn't more than the remaining debt principal, the refinanced debt will still be grandfathered debt. If the new debt exceeds the mortgage principal on the old debt, the excess will be treated as home acquisition or home equity debt.

Grandfathered debt that was refinanced is treated as grandfathered debt only for the period that remained on the old debt that was refinanced. Once that period ends, you must treat the debt as home acquisition debt or home equity debt, based on how the debt proceeds are used. There's an exception that allows a longer period of deduction for balloon notes that are refinanced after Oct. 13, 1987.

Points. In general, points that you pay to refinance your home aren't 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.

To figure your deduction for points, divide the total points by the number of payments to be made over the life of the loan. Then, multiply this result by the number of payments you made in the tax year.

For example, if you paid $3,000 in points and you will make 360 payments on a 30-year mortgage, you can deduct $8.33 per monthly payment. For a year in which you make 12 payments, you can deduct a total of $99.96 ($8.33 × 12).

However, you may be entitled to a larger first-year deduction for points if you used part of the proceeds of the refinancing to improve your home and you meet certain other requirements. In that case, the points associated with the home improvements may be fully deductible in the year they were paid.

For example, say that you refinance a high-rate mortgage that has an outstanding balance of $80,000 with a new lower-rate loan for $100,000. You use the proceeds of the new mortgage loan to pay off the old loan and to pay for $20,000 of improvements to your home. Since 20% of the new loan was incurred to pay for improvements, 20% of the points you paid can be deducted in the year of the refinancing.

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 at the time of the second refinancing.

Penalties and fees. A prepayment penalty that you pay to terminate your old mortgage is deductible as interest in the year of payment.

However, fees paid to obtain the new mortgage aren't deductible, nor can you add them to your basis in your home to reduce the gain when you sell it. Examples of such nondeductible fees are credit report fees, loan origination fees, and appraisal fees.

[back to top]


Tax breaks for individuals in the Economic Growth and Tax Relief Reconciliation Act of 2001

Congress recently passed a major tax bill. Although many of its provisions won't go into effect for several years, most individuals will see at least some income tax benefits this year. These include a new 10% bracket, an across-the-board one-point cut on July 1 in each of the current tax brackets above the 15% bracket, modest relief from the alternative minimum tax (AMT), and a higher child credit. Here is a brief overview of these tax changes.

New 10% bracket. The Act carves a new 10% bracket out of part of the current 15% bracket. Specifically, the first $6,000 of taxable income for singles and married taxpayers filing separately, $10,000 for heads of household, and $12,000 for married persons filing joint returns, will be taxed at 10%. Individuals will get the benefit from the new bracket for 2001 in the form of checks from the federal government of up to $300 for a single person or married individual filing separately, up to $500 for a head of household such as a single parent, and up to $600 for a married couple. Individuals who are eligible to be claimed as dependents on another taxpayer's return (such as a dependent child) and nonresident aliens won't get a check..

IRS officials expect to start cutting checks (called "advance refund checks") in August at a rate of about nine million a week, based on 2000 income tax returns. The Act instructs the Treasury to send the advance refund checks by Oct. 1, but people who filed late or got filing extensions may get their checks later. The payments will be made in numerical order based on the last two digits of the lead Social Security number on the tax return. Those eligible individuals who filed no tax return for 2000 or owed no tax will benefit from the 10% bracket when they file their 2001 tax return -- they'll get a credit of up to $300, $500, or $600, depending on filing status.

One-point across-the-board tax-rate cut. As the first installment of the individual income tax rate cuts that will unfold over the next five years, the "old" income tax rates of 28%, 31%, 36% and 39.6% will each be reduced by one percentage point, effective July 1 of this year, resulting in blended tax rates for all of 2001 of 27.5%, 30.5%, 35.5% and 39.1%, respectively. The 15% rate, however, will remain unchanged. In the near future, the Treasury Department will notify employers of new withholding schedules, which will be adjusted to reflect the initial one-percentage-point reduction in tax rates. The lower marginal rates should result in slightly bigger paychecks as the amount withheld for taxes is reduced.

Modest AMT relief. The Act provides only limited, temporary alternative minimum tax (AMT) relief for individuals. To find out if you owe AMT, you start with regular taxable income, modify it with various adjustments and preferences (such as addbacks for property and income taxes and dependency exemptions), and then subtract an exemption amount. The result is subject to an AMT tax rate of 26% or 28%. You pay the AMT only if it exceeds your regular tax bill. For 2001, the Act increases the AMT exemption amount by $4,000 for married taxpayers filing joint returns, and by $2,000 for other individuals. However, the AMT exemption amount phases out at higher levels of income, and the boosted exemption will only remain in place through 2004. Many taxpayers, particularly those residing in states with high income and/or property taxes, will not receive the full benefit of the new tax cuts and instead will have to pay the AMT unless Congress enacts additional AMT relief. Thus, it is still necessary to plan how to avoid or at least reduce the AMT.

Higher child credit. Parents of dependent children younger than 17 may claim a tax credit per child, if parental income doesn't exceed certain dollar limits. (A tax credit reduces your tax bill dollar for dollar, as opposed to a deduction, which reduces the amount of your income subject to taxation.) Under the 2001 Act, the maximum credit per child increases from $500 to $600 for 2001, meaning that eligible taxpayers will be able to claim the additional $100 credit on their 2001 returns filed next year. In later years the credit gradually climbs until it reaches $1,000 in 2010.

Looking down the road. Much of the $1.35 trillion tax cut in the 2001 Act will take longer to materialize. Many of the larger tax cuts in the Act don't kick in until 2002 or later. Some new tax breaks phase in over the next decade, while some current rules phase out over that period, creating tax-planning challenges for everyone. If you would like to discuss how the Act may affect your individual tax and financial planning situation, please do not hesitate to call.

[back to top]

Avoiding Inadvertent Termination of S Corporation Status

Now that you have chosen the S corporation form for your business, you should be aware of certain steps that you should take to avoid an inadvertent termination of S corporation status.

o Avoid transfers to ineligible shareholders. In general, the only types of shareholders which an S corporation may have are individuals who are U.S. citizens or residents, a decedent's estate, certain types of trusts, and certain exempt organizations. Therefore, it is important that you confirm that all the shareholders are eligible to be S corporation shareholders -- i.e., that no shareholder is a nonresident alien, a partnership, or a corporation; that all trusts are properly structured to be eligible shareholders; and that any elections required for a trust have been made. Even if a corporation's initial shareholders are all eligible shareholders, S corporation status will be terminated if any shares are transferred to a nonresident alien individual, a corporation, a partnership, or a trust (other than the specific types of trusts which are permitted to be S corporation shareholders).

In order to prevent a shareholder from causing a termination of S corporation status by transferring his shares to an ineligible shareholder, a shareholders' agreement should prohibit transfer of any shares to a person other than a permitted S corporation shareholder, and require a similar undertaking on the part of any transferee, as a condition to any transfer. In addition, if permitted by local law, an appropriate restriction should be imposed in the corporation's charter or by-laws so that a purported transfer to an ineligible shareholder would be void.

o Avoid violating the shareholder limitation. An S corporation cannot have more than 75 shareholders. Even if this limit is not exceeded initially, S status will terminate if, as a result of new issuances or transfers of shares, the limit is exceeded at any time in the future. New issuances of stock require corporate action, and you should keep this rule in mind when considering future issuances of stock so that the 75 shareholder limitation will not be exceeded.

Transfers by shareholders can be somewhat more problematic, since they can occur without any action on the part of the corporation. Therefore, if the transfer would cause the 75-shareholder limit to be exceeded, a shareholders' agreement should prohibit the transfer of any shares to a person who is not already a shareholder. A similar restriction should be imposed on the transferee. In addition, if permitted by local law, an appropriate restriction should be imposed in the corporation's charter or by-laws so that a purported transfer that caused the limit to be exceeded would be void.

o Don't issue more than one class of stock. An S corporation can only have one class of stock. Be sure to keep this requirement in mind when considering future changes to the capital structure of the corporation. The IRS allows S corporations to use various equity incentive compensation arrangements without violating the one class of stock restriction. If you want to create an equity incentive compensation plan, I would be happy to discuss with you how to structure the plan.
o Avoid excess passive investment income. If an S corporation has accumulated earnings and profits (because it was once a C corporation or is a transferee of a C corporation), its S election will terminate if, for a period of three consecutive tax years, its "passive investment income" exceeds 25% of its gross receipts. The first step in avoiding an inadvertent termination under this rule is to keep track of the corporation's passive investment income to determine whether the 25% limitation may be exceeded. Although excess passive income is subject to a special tax, S corporation status will terminate only if the limit is exceeded for three consecutive years. Thus, if you are willing to pay the tax, you can monitor the results of two years' operations while you plan to avoid a termination.

If a corporation is in danger of exceeding the 25% passive income limitation for three years, there are two basic approaches to avoid termination of S corporation status. Since termination will only occur if the corporation has accumulated earnings and profits from C corporation years, termination can be avoided by stripping out those earnings and profits by way of a dividend. Ordinarily, distributions by an S corporation reduce pre-S corporation earnings and profits only after the accumulated income from all S corporation years has been distributed. However, it is possible to elect to treat distributions as coming from pre-S corporation earnings and profits first. Moreover, if it desired to strip out earnings and profits without actually depleting the corporation's cash or other liquid assets, a "deemed" dividend election can be made. Be aware, however, that a distribution out of pre-S corporation earnings and profits (whether actual or under the deemed dividend election) is generally taxable to shareholders as a dividend (unlike a distribution from accumulated S corporation income which is generally a return of capital).

A second approach to avoiding termination under the passive income rules is to tailor the corporation's operations so that the 25% passive income limit is not exceeded. Since termination will occur only after the limit is exceeded for three consecutive years, if you are willing to incur the tax on excess passive income, there should be sufficient time to take action to avoid a termination.

This can be done by reducing the amount of passive investment income, or by increasing the amount of other income. Since the test is applied to gross receipts, acquiring a business which produces receipts which are not passive investment income, even if it does not produce much in the way of net income, is one possible solution. It may also be possible to restructure certain operations so that passive income (e.g., certain rental income) becomes active income. (Unfortunately, an investment in municipal bonds producing tax-exempt interest is not a solution under these rules.)

If it turns out that, despite appropriate precautions, S corporation status is nevertheless terminated, all is not lost. It is possible to apply to IRS for a "waiver" of an inadvertent termination of S status. Naturally, the safest course of action is avoid a termination in the first place.

If you have any further questions, or if you'd like me to go into the appropriate provisions to avoid transfers of stock which would cause a termination, please telephone us.

[back to top]


Why an S Shareholder Reports More Than He Receives

Why is it, in a given year, you may be taxed on more S corporation income than was distributed to you from the S corporation in which you are a shareholder.

The answers lies in the way S corporations and their shareholders are taxed. But before explaining those rules, let us assure you that when you are taxed on undistributed income, you won't be taxed again if and when the income ultimately is paid to you.

Unlike a regular or C corporation, an S corporation generally isn't subject to income tax. Rather, each shareholder is taxed on the corporation's earnings, whether or not the earnings are distributed. Similarly, if an S corporation has a loss, the loss is passed through to the shareholders. Various rules, however, may prevent a shareholder from currently using his share of the corporation's loss to offset other income.

While an S corporation generally isn't subject to income tax, it is treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass on to shareholders their share of these items.

An S corporation must file an information return (Form 1120-S). On Schedule K of this form, the corporation separately identifies many items of income, deduction, credits, etc. This is so that each shareholder can properly treat items that are subject to limits or other rules that could affect their correct treatment at the shareholder's level. Examples of such items include capital gains and losses, charitable contributions, and interest expense on investment debts. Each shareholder gets a Schedule K-1 showing his share of these items.

Basis and distribution rules ensure that shareholders aren't taxed twice. A shareholder's initial basis in his stock (the determination of which varies depending on how the stock was acquired) is increased by his share of the S corporation's taxable income. When that income is paid out to shareholders in cash, they aren't taxed on the cash if they have sufficient basis. Rather, shareholders merely reduce their basis by the amount of the distribution. If a cash distribution exceeds a shareholder's basis, then the excess is taxed to the shareholder as a capital gain.

Example: Anderson and Baker each contribute $50,000 to form an S corporation. The corporation has $100,000 of taxable income in Year 1, during which it makes no cash distributions to Anderson or Baker. Each of them pick up $50,000 of taxable income from the corporation as shown on their K-1s. Each has a starting basis of $50,000, which is increased by $50,000 to $100,000. In Year 2, the corporation breaks even has zero taxable income and distributes $50,000 to Anderson and a like amount to Baker. Anderson and Baker have no income from the corporation in Year 2. Plus, the cash distributed to them is received tax-free. Each of them, however, must reduce the basis in his stock from $100,000 to $50,000.

In reality, the basis and distribution rules are far more complicated. For example, many other events require basis adjustments and there are a host of special rules covering distributions from an S corporation having accumulated earnings and profits from a tax year when it was a regular corporation.

Please call us if you wish to further discuss any aspect of how you are taxed as an S shareholder.

[back to top]


HOPE Credit and Lifetime Learning Credit for Higher Education Expenses

The HOPE credit and the Lifetime Learning credit for "qualified tuition and related expenses" (see below) may allow you to turn part of the higher education expenses you incur for yourself, your spouse, or your dependents into tax savings.

The maximum HOPE credit a taxpayer may claim is $1,500 per year per student, for the first two years of undergraduate education at an eligible educational institution. The maximum HOPE credit amount will be adjusted for inflation after 2001. The maximum Lifetime Learning credit that may be claimed is $1,000 per year ($2,000 per year after 2002) per taxpayer, for any post-high school education (including graduate-level courses and courses to acquire or improve job skills) at an eligible educational institution. The maximum Lifetime Learning credit will not be adjusted for inflation.

Generally, eligible educational institutions are accredited schools offering credit toward a bachelor's or associate's degree or other recognized post-high school credential, and certain vocational schools.

The HOPE credit is available only for the qualified tuition and related expenses of an eligible student, i.e., a student who's enrolled in a degree or certificate program at an eligible educational institution on at least a half-time basis, and who has never been convicted of a federal or state felony drug offense. The Lifetime Learning credit is not subject to the eligible student/felony drug offense restrictions, and may be available for a student taking only one course.

The HOPE credit and the Lifetime Learning credit aren't allowed for an expense that's otherwise deductible. But, for qualified tuition and related expenses paid in 2002-2005 for an individual, an otherwise eligible taxpayer may choose to claim the appropriate credit or the deduction allowed for those years for higher education expenses.

The HOPE credit and the Lifetime Learning credit may not be claimed in a year when the student receives any tax-exempt distribution from an education individual retirement account (that is, an education IRA). However, beginning next year (in 2002), a taxpayer may claim a HOPE credit or a Lifetime Learning credit for a tax year and exclude from gross income amounts distributed (both the principal and the earnings portions) from an education IRA for the same student, as long as the distribution is not used for the same educational expenses for which a credit was claimed. Similarly, a taxpayer may claim a HOPE credit or Lifetime Learning credit for a tax year and also exclude from gross income amounts distributed (both the principal and the earnings portions) from a qualified tuition program on behalf of the same student, as long as the distribution isn't used for the same expenses for which a credit was claimed.

The HOPE/Lifetime Learning credits may not be claimed in the same tax year for the same expenses, but each may be claimed for different expenses. For example, in the same tax year, a taxpayer may claim the HOPE credit for the qualified tuition and related expenses of one or more qualifying dependents, and may claim the Lifetime Learning credit for the qualified tuition and related expenses incurred for himself.

In order to be eligible for the HOPE credit or the Lifetime Learning credit for a tax year, qualified tuition and related expenses must be paid during that tax year for education furnished during an academic period (e.g., semester) that starts within that tax year or within the first three months of the following year. Under this rule, taxpayers have a timing option. For example, for a semester beginning in Jan. of Year 2, a taxpayer may pay the expenses in Year 1 or Year 2. The credit will be available in whichever year the payment is made.

The HOPE/Lifetime Learning credits are nonrefundable -- i.e., they can reduce regular income taxes to zero but cannot result in the receipt of a refund. For 2000 and 2001, they can also be used to reduce the alternative minimum tax to zero. After 2001, the credits will be allowed only to the extent that the taxpayer's regular income tax liability exceeds his or her tentative minimum tax.

If the expenses on which the HOPE/Lifetime Learning credits are based are later refunded, the credits may have to be recaptured -- i.e., the tax for the refund year may be increased to account for a recomputed credit for the earlier year.

As noted above, the HOPE/Lifetime Learning credits are based on the payment of qualified tuition and related expenses. These are the expenses for tuition, books and academic fees that are required for enrollment or attendance at an eligible educational institution. Qualified tuition and related expenses do not include student activity fees, athletic fees, insurance expenses, room and board, transportation costs and other personal living expenses. They also don't include the cost of any course or education involving sports, games, or hobbies unless the course or education is part of the student's degree program.

The amount of qualified tuition and related expenses taken into account in computing the HOPE/Lifetime Learning credits must be reduced by tax-exempt scholarships and fellowships, certain military benefits, and any other tax-exempt payments of those expenses other than gifts or bequests.

Both the HOPE credit and the Lifetime Learning credit are phased out ratably for married taxpayers filing jointly with adjusted gross income (AGI), with certain modifications, between $80,000 and $100,000. That is, the credit is reduced if the modified AGI is above $80,000 and is unavailable if it's $100,000 or more. For taxpayers who aren't married filing jointly, the phase-out range is $40,000 to $50,000. After 2001, the phase-out amounts will be adjusted for inflation.

Neither the HOPE credit nor the Lifetime Learning credit is available for taxpayers who are married filing separately.

In addition, neither the HOPE credit nor the Lifetime Learning credit is allowed to an individual who is claimed as a dependent on another's return. In this situation, the HOPE/Lifetime Learning credits are allowed instead to the taxpayer claiming that individual as a dependent, and the credits are based on the total qualified tuition and related expenses paid both by the taxpayer and the student. But if no one claims the student as a dependent on a tax return for the year, the HOPE/Lifetime Learning credits are allowed to the student on his or her own return, based on the expenses paid by the student. In either case, the student's credit takes into account the expenses that a third party (e.g., the student's grandparent) pays to the eligible educational institutional directly.

Eligibility for the HOPE and Lifetime Learning credits are subject to a number of technical requirements not discussed above. Please give us a call if you would like to discuss your eligibility for these credits and how to claim them.

[back to top]


Taxation of barter income

As the owner of a business, you may sometimes find it to your advantage to barter for goods and services rather than paying in cash. You should be aware, however, that the fair market value of goods and that you receive in bartering is taxable income, just as if you had received a cash payment.

Exchanges of services result in taxable income for both parties. Say, for example, that a computer consultant agrees to an exchange of services with an advertising agency. Both parties to the transaction are taxed on the fair market value of the services received. This is the amount they would normally charge for the same services. If the parties agree to the value of the services in advance, that will be considered the fair market value unless there is contrary evidence.

Income is also realized where services are exchanged for property. For example, if an architectural firm does work for a corporation in exchange for shares of the corporation's stock, it will have income equal to the fair market value of the stock.

Many business owners join barter clubs that facilitate barter exchanges. These clubs generally use a system of "credit units" that are awarded to members who provide goods and services and can be redeemed for goods and services from other members.
If you participate in a barter club, you'll be taxed on the value of credit units at the time they are added to your account, even if you don't redeem the units for actual goods and services until a later year. For example, say that in Year 1 you earn 2,000 credit units, and that each unit is redeemable for one dollar in goods and services. In Year 1, you'll have $2,000 of income. You won't pay additional tax if you redeem the units in Year 2, since you've already been taxed once on that income.

When you join a barter club, you'll be asked to give the club your social security number or employer identification number and to certify that you aren't subject to backup withholding. Unless you make this certification, the club must withhold tax from your bartering income at a 31% rate.

By Jan. 31 of each year, the barter club will send you a Form 1099-B, which shows the value of cash, property, services, and credits that you received from exchanges during the previous year. This information will also be reported to IRS.

[back to top]


Qualified tuition programs--"529 plans"

If you have a child (or if you'd like to help someone else's child) who is going to attend college in the future, you may be interested to know that our state has set up a qualified tuition program that allows prepayment of higher education costs on a tax-favored basis. These programs are sometimes referred to as "529 plans," for the Code section that provides for them.

Under the program, funds that you place in the program are held in a special account to be used to cover the future higher education costs of the child you designate as beneficiary. The earnings on the account aren't taxed while the funds are in the program. Instead, at the time the funds are used for the child's higher education, the earnings (but not the contributions) will be taxed to the child. And since the child is likely to be in a low tax bracket when using the funds, the earnings will be taxed at a favorable rate. Further, there is no tax on distributions to the extent the funds are used to pay qualified expenses. Also, private education institutions will be allowed to establish programs, but distributions from those programs won't be tax-free until 2004.

Tuition, fees, books, supplies, and required equipment can be prepaid through our state's qualified tuition program. What's more, reasonable room and board expenses of a student who is enrolled at least half-time may also be prepaid.

Accredited colleges, junior colleges, and area vocational schools are qualified to participate in the tuition program. In addition, accredited post-secondary schools offering credit towards a bachelor's degree, an associate's degree, a graduate or professional degree, or another recognized post-secondary credential, are eligible to participate. Certain proprietary institutions and post-secondary vocational education institutions that are eligible to participate in Department of Education student-aid programs may also participate in the qualified tuition program.

The contributions you make to the qualified tuition program are not subject to gift tax, except to the extent the contributions exceed $11,000 annually (indexed for inflation). And if your contributions in a year exceed $11,000 (as indexed for inflation), you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions.

Please note that if a distribution of earnings isn't used for qualified higher education expenses of the beneficiary, a 10% additional tax will be imposed on the distribution.
A distribution from a qualified program isn't a gift, but a change in beneficiary or rollover to the account of a new beneficiary is.

[back to top]

Copyright © 2010 Sadoff, Fischer & Associates, P.A.
Home  About Us  Our Service  Contact Us
Links  Newsletters  Our Privacy Policy