Wealth Management Guru: Home Sweet Home

Even though the value of your clients' homes isn't reflected in the assets you manage (and don't get any funny revenue-boosting ideas), these residences do represent a significant chunk of their net worths. And the sentimental value they attach to these holdings is probably disproportionately larger.

Residential real estate also provides its fair share of tax breaks and loopholes. But many homeowners are ill-informed about — or completely ignorant of — these exemptions. And that lack of accurate information can cause clients to miss out on major tax-cutting opportunities or, worse yet, make unrealistic or faulty financial decisions.

Here are the most common tax advantages of home ownership available to typical clients, along with strategies to help you help them make the most of their breaks.

Mortgage Interest

Clients who itemize can deduct the interest on first and second mortgage balances up to $1,000,000, and $500,000 for married filing separately. The mortgage must be secured by the home, but almost all mortgages are. The clients can even get a deduction on interest paid on a mortgage on a second home, subject to the aggregate limits mentioned above.

Even interest incurred on home equity loan balances and line of credit balances of $100,000 or less is tax-deductible — no matter how the borrowed money is spent. The deduction can turn the “effective” rate of the interest into a surprisingly low number. A couple in the 33 percent federal tax bracket and 6 percent state bracket with a $250,000 mortgage at 6 percent has an after-tax interest cost of about 3.8 percent.

The good news is that mortgage interest is one of the few deductions that are allowed even if your clients are subject to the dreaded alternative minimum tax. The bad news is that for married-filing-jointly taxpayers with an adjusted gross income (AGI) of more than $166,800 in 2009, their deductions (including mortgage interest) may be phased out according to the amount of income that exceeds that AGI floor.

Planning tip: High-income clients who can deduct mortgage interest should make extra mortgage payments only after they have paid off all other debt and maxed out their pre-tax retirement plan contributions. Also, when buying a big-ticket item like a car or boat, those in the higher income brackets should at least consider tapping their home equity instead of taking out a higher-interest, non-deductible loan.

Property Taxes

Typically, homeowners must also itemize to get a tax deduction on property taxes paid. With the 2009 standard deduction at $11,400 for married couples filing jointly ($5,700 for singles), it usually takes a decent home to get enough deductions to justify itemizing.

However, a new law gives limited relief to those who pay property taxes, but just take the standard deduction. In the 2008 and 2009 tax years they can still deduct the lower amount of their property taxes paid, or $1,000 for couples filing jointly (for singles, its $500).

Woe be unto those homeowners who get snared by the alternative minimum tax because, unlike mortgage interest, property taxes are not deductible in the AMT calculation. Sadly, property taxes do have one thing in common with mortgage interest in that deductions for property taxes are also subject to a phase-out for higher income earners.

Planning tip: If your clients don't have enough deductions to justify itemizing, they may want to pay two years' worth of property taxes in one calendar year (and itemize), and then take the standard deduction the next year. You can then repeat the process.

Capital Gains

If the clients live in a home as their principal residence for at least two of the five years preceding a sale, up to $250,000 of the profit from a sale is excluded from taxation for singles, and up to $500,000 for married couples who file jointly.

A new wrinkle to this rule was added last year, in that a widow or widower can still get the full $500,000 exemption, as long as he or she sells the home within two years after the death of the first spouse. The capital gains exclusion benefit won't provide much help to sellers who recently purchased homes, and may be “underwater” for some time. But long-time homeowners could still save big.

Say a couple bought a home for $400,000 twenty years ago, and after an annual appreciation of 4 percent, sells it for a net price of $900,000. Assuming they met the residency requirements, the exclusion could save them over $71,000 in long-term capital gains taxes.

And the advantage could grow even larger if tax rates of long-term capital gains are raised back to previous levels of 20 percent or more.

Planning tip: Realizing losses now for clients in their “paper” portfolios and then carrying the losses forward can help offset any capital gains from a future home sale that exceed the excluded amount.

Reverse Mortgages

With barely a hundred thousand or so of the most prevalent kinds of reverse mortgages originated in the last 12 months, this tool is not widely used by retirees — yet.

However, usage should grow dramatically over the next several years, especially when retirees realize the tax benefits that reverse mortgages provide.

Much like payments from other types of home equity loans, the proceeds of reverse mortgages are tax-free. The accumulating interest is taxable, but only when the homeowner sells the home or passes away.

The proceeds from the sale in either event can be used to pay off the reverse mortgage amount (including interest). The interest may be tax deductible at the time of payoff.

In the meantime, clients can get income that they can't outlive and that won't push them up into a higher tax bracket.

Planning tip: Reverse mortgage proceeds are not only tax-free, but unlike interest from municipal bonds, the income generated won't affect the taxation of retirees' Social Security benefits.

Writer's BIO:

Kevin McKinley
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.advisortipsheet.com.

TEST CASE

Say a 75-year-old widow has a home worth $400,000 that she and her late husband bought for $25,000 long ago. She gets $1,000 in Social Security each month, and has $250,000 in CDs earning 4 percent interest. She needs income, and is considering selling her house and reinvesting the net proceeds in more CDs at 4 percent. If she were to take out a reverse mortgage instead, her after-tax annual income could be $6,460 higher in this simplified example, and she would be able to remain in her home for as long as she wants: