Selling a house you have owned for a long time? Going to buy a new one? Anyone faced with the prospect of selling a house bought when fixed-rate mortgage loans cost only 6 to 9 1/2 percent interest, then rebuying in today's market, needs to consider various tax liabilities and how new regulations might affect such transactions.
The option remains of deferring tax on any capital gain on the house, the gain being the difference between market value today over the cost basis. Currently, you must move into a replacement house within 24 months on sales after July 20, 1981.
Whether deferral is desirable may be affected by two options:
1. For people over 55, single or couples, who have lived in their house for three of the five years preceding the sale, the option of exempting up to $125, 000 remains. The new figure, up from $100,000, is effective for sales after July 20, 1981.
2. People who elect to retain their house and rent it for income might pay the capital-gains tax -- long term if the house was owned for longer than one year. Through the end of 1981, the tax is a maximum of 28 percent (70 percent of 40 percent that remains after the 60-percent exclusion). Beginning in 1981, a maximum of 50 percent applies, and the tax will not exceed 20 percent.
Creative financing, whereby the owner "holds the paper" and in effect finances all or a portion of the loan when you buy a house, does not really affect tax liabilities, except for timing. Neither is the situation changed by the various forms of alternative mortgage financing, whereby the interest rate is adjustable over the loan period. Whether a new homeowner pays interest to the former owner or to a savings-and-loan or other institution is incidental. Interest is deductible when computing taxes using a long Form 1040.
Recent changes in tax legislation aim to simplify reporting for a larger segment of the population. Thus, the standard deduction has been increased, and for many, the opportunity to deduct house loan interest by itemizing is lost. Bracket creep, whereby people with increasing income reach higher and higher marginal tax brackets, must also be considered.
If you have been using a standard deduction and are considering buying a new house with a high interest rate on the loan, look at the tax options of using the standard deduction vs. itemizing. If you are in the zone where itemizing will save on taxes, consider the aftercost of home loan interest. If you pay taxes at a 38-percent marginal rate, you would be paying an after-tax rate of 9. 3 percent if the base rate were 15 percent, as an example. But remember, this rate would apply only if all of the home loan interest exceeds the standard deduction. If you need the home loan interest to reach and exceed the standard deduction, then the effective rate will be higher.
Some adjustable-rate mortgage loans provide for higher interest payments on a graduated scale or in response to an index. Look ahead to see how the interest portions of these payments will affect itemized deduction totals and your increasing marginal tax brackets as income increases.