There are a number of important tax law changes that take effect this year, including three changes that will affect some homeowners. There are also changes that impact business owners.

While you won’t see the impact of these changes until you file your returns early in 2009, it helps to know about them now so you can keep proper records and make the smartest decisions for your money.

Take a few minutes to review the changes so you can keep them in mind as you devise your 2008 tax strategies.

Changes for Homeowners

Homeowner’s Exemption: In the past, taxpayers have taken the opportunity to convert a rental property or vacation home into their primary residence and then later sell the property. This allowed them to take advantage of the Homeowner’s Exemption which allows a taxpayer to exclude up to $250K ($500K for married couples) of gain realized on the sale of a primary residence. An example of a common strategy has been:

• Taxpayer acquires rental property in 2000 for $100K.
• Taxpayer rents the property out for three years.
• In 2003, taxpayer moves into the property as his/her primary residence.
• In 2005, taxpayer sells the property for $600K.
• Taxpayer (married couple) avoids paying taxes on the entire gain ($500K).

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Following is an excerpt from John Mauldin’s “Thoughts from the Front Line” and a link to the entire piece. It’s lengthy but a great articulation of the current financial situation and proposed government intervention. It is in the form of a letter to Congressman Joe Barton, TX, a top Republican House leader. John Mauldin is a multiple NYT Best Selling author and recognized financial expert. He has been heard on CNBC, Bloomberg and many radio shows across the country. He is the editor of the highly acclaimed, free weekly economic and investment e-letter that goes to over 1 million subscribers each week.

It’s the End of the World As We Know It

Dear Joe,

I understand your reluctance to vote for a bill that 90% of the people who voted for you are against. That is generally not good politics. They don’t understand why taxpayers should spend $700 billion to bail out rich guys on Wall Street who are now in trouble. And if I only got my information from local papers and news sources, I would probably agree. But the media (apart from CNBC) has simply not gotten this story right. It is not just a crisis on Wall Street. Left unchecked, this will morph within a few weeks to a crisis on Main Street. What I want to do is describe the nature of the crisis, how this problem will come home to your district, and what has to be done to avert a true, full-blown depression, where the ultimate cost will be far higher to the taxpayers than $700 billion. And let me say that my mail is not running at 10 to 1 against, but it is really high. I am probably going to make a lot of my regular readers mad, but they need to hear what is really happening on the front lines of the financial world.

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One of the costs of living in the Bay Area, and California for that matter, is that you are much more likely to owe AMT (Alternative Minimum Tax) when you file your personal Federal Tax Returns. Other than an act of congress to change the tax law, there’s not much you can do about it. The silver lining on this cloud has to do with… your mortgage.

The original AMT established in 1970 targeted tax shelters used by a few wealthy households and was greatly expanded in 1986 to aim at a different set of deductions that most Americans receive. The AMT sets a minimum tax rate of either 26% or 28% on some taxpayers so that they cannot use certain types of deductions to lower their income tax obligation. Sounds reasonable, right? I mean, why should people who are making millions of dollars be able escape paying their fair share of income tax!? Well, because of the way the AMT is structured, welcome to the life of the rich and famous!

According to the Congressional Budget Office, “Over the coming decade, a growing number of taxpayers will become liable for the AMT. In 2010, if nothing is changed, one in five taxpayers will have AMT liability and nearly every married taxpayer with income between $100,000 and $500,000 will owe the alternative tax.” That will be over 30 million household.

But why are we Californians affected more than the rest of the population? First, incomes in the Bay Area are statistically higher than the rest of the country. But here is the more specific reason: two of the disallowed deductions through the AMT schedule are state income tax and real estate tax.

As of 2007, the highest rate of state income tax is that of California, with a maximum rate of 10.3%. Under the standard 1040 tax schedule, if you itemize your deductions, you are allowed to deduct what you pay in state income tax. Not so under the AMT schedule. Despite the real estate downturn over the past year, values in many places in the Bay Area have remained stable and are still one of the highest priced areas in the US. Property taxes are often a significant part of one’s housing expense, to the tune of 1.25% per year of the assessed value of your home. This too is excluded under the AMT. So what’s a newly rich & famous person to do?

Generally speaking, the interest that you pay on your mortgage for your home remains deductable under AMT. That’s a bit of a blanket statement, so don’t take it as gospel. I’ve discussed this with the brightest of CPAs and they still will say “well… there may be some other issues”. The point being talk with your CPA or Tax Advisor. Nonetheless, let’s go through an example of how this can remain a tax benefit of having deductable mortgage interest on the AMT.

Let’s say you have a $500,000 qualified mortgage and pay 6% interest (and for simplicity let’s say your mortgage payment is interest only). You would have paid $30,000 of interest over the course of the year. If you are subject to the 26% AMT rate and approximately 10% California tax rate, that $30,000 would give you an approximate $10,800 reduction in your tax liability. This basically means that because of the deduction (even under the AMT), that 6% interest rate is costing you about 3.8% on an after-tax basis. Not bad.

What the moral of the story? Tax Efficiency. In the words of Ben Franklin… “In this world nothing can be said to be certain, except death and taxes.” If you accept that premise, then it would be wise structure your mortgage and money to be tax efficient. It’s not too complicated but it can be complex. For the do-it-yourselfers, run through pro formas on your Turbo Tax or other income tax preparation programs. For the rest of us, get good help from a skilled CPA or tax advisor. You need to do this whenever you are buying, refinancing or messing with your mortgage. You could inadvertently make a move that would eliminate your tax benefits.

Fannie Mae and Freddie Mac were taken over by the US government on September 7th, 2008. This is result of the unprecedented changes that are occurring in the US financial and real estate markets. And there is no doubt at this point that the effects of our liquidity crisis will be felt worldwide. Yet, what does it mean for top 1% income earners that are also consumers of US mortgages? (If you’re wondering, you are in the 90th percentile of income earners if your annual household income is over $150,000; top 1% is above $250,000.) It has been almost two decades since the recession and real estate downturn of the early 1990s brought on by, among other things, the Savings & Loan crises. As we learned back then, top 1% income earners are not immune. I’d like to offer my speculation about the risks and opportunities available in the current volatile marketplace.

In the short term, I believe we will see falling interest rates as the US government touts increased liquidity and the international markets cheer the savior of their large investments in the US mortgage markets. This drop has already occurred as rates fell more than 1/2% in the last couple of days in treasury yields and certain conforming and so-called conforming-jumbo mortgages. This could be positive for a large group people currently holding US properties encumbered with interim fixed period ARM loans that are due to reset in 2009. I believe we are going to see a massive refinancing movement while these rates are low and this may act to lessen the blow of the second wave of foreclosures due to hit the US next year. Rates on many 30 year mortgage products are now at or below 6% which is extremely low in terms of historical averages at 9%. Note that many property owners will still not be able to refinance due to the drop in property values and the lack of their ability to get a satisfactory appraisal, as well as stricter underwriting guidelines. Yet, I think it is safe to say that this second wave of foreclosures is going to be less dramatic than the first wave that was primarily attributed to defaults of sub-prime mortgages. The first crippling wave of foreclosures during 2007 and 2008 was a product of highly risky sub-prime loans done in mass and then abruptly stopped as the markets collapsed.

Yet, it is my belief that unabashed glee is short sided. The takeover will shift Fannie Mae and Freddie Mac’s losses to US tax payers. If you are a taxpaying US citizen who does not own real property, then you are exposed to the financial burden without any of the benefits of owning real estate. Someone will eventually have to pay the piper for these losses and it now appears that this burden will be heaped on top of the US’s national debt that is already staggeringly high. Just like individuals cannot expect to heavily leverage themselves without consequence, neither can governments. Thus I speculate that in order for our government to strengthen its position in the global economy we will need to drastically cut debt and this translates into increased taxes and slashed government programs. We are already experiencing this issue of increasing taxes and reducing government programs at the state level as California once again struggles to pass a balanced budget. An increase in taxes means additional financial pressure that will have to be levied on US citizens at some point in time. This will be a destructive consequence to the US economy.

Now more than ever top 1% income earners who endeavor to capitalize on their existing assets and/or enter the real property markets need superior help. Questions such as whether or not to refinance existing debt, if to sell and/or buy now, trade up, what financial structures are most tax efficient, and so forth, are vital to answer in order to preserve and increase their wealth. The answers to these questions will significantly impact the profitability or loss in your real property transactions, whether for investment or for your personal residence. It is critical that your financial, real estate and tax advisors are able to make powerful interpretations of your current and future situation. When there is a disruption in the marketplace, such as our current economic situation, there is heightened risk and also amplified opportunity. Make sure that your advisors are capable of handling all of your concerns during this turbulent time. If you are looking for financial, mortgage or real estate assistance feel free to contact us for a free initial consultation so we can adequately assess your needs.

Divorce, or variations on that theme, is starting to look almost as certain as death and taxes… the national average seems to be holding with about 1 out of 2 marriages ending in divorce. Among my friends, family and clients, it seems the number of couples around me calling it quits has escalated over the past few years. I suppose it could simply be my age, the circles I travel in and living in California. With splitting couples, very often their home will be their single largest asset. They may even fight tooth-and-nail to keep the home and send their “ex” packing. Here’s the thing: this could be a huge financial mistake. Often the consequences are not realized until long after signing the settlement agreement. Generally there are three issues around real estate that come up that are often overlooked in a divorce.

The first issue has to do with the property as an asset class and liquidity. Let’s say a couple (Popeye and Olive Oyl) owns a home worth $1,000,000 free & clear, i.e. no mortgage. And in addition, they have $1,000,000 of cash and invested assets. They agree to split everything 50/50. But Olive Oyl wants the home. So she will give Popeye her half of the cash in trade for his half of the house. Though Olive now has a place to live, she has 100% of her assets invested in real estate with no liquidity (unless she sells or finances some of the equity out of the property). This is equivalent to having all of your money tied up in one single, privately held investment… not real consistent with Modern Portfolio Theory.

The next issue has to do with affordability and qualifying. Let’s say Popeye and Olive have a $500,000 mortgage. The payment on the house with property taxes and insurance is $4000 per month. Olive only has to give Popeye $250,000 of her cash to buy him out. So she has $250,000 left in cash plus the house with the mortgage. The first question is can she afford the payment? That’s a much bigger question than I can address here, so let’s say she thinks she can handle the payment. But Popeye doesn’t let her get off the hook so easy. Since both signed the mortgage obligation when they were married, Popeye will remain liable from the lender’s point of view even though he may not be on the title as an owner of the property. If Olive can’t qualify on her own either for a new mortgage or in assuming the current one, Popeye may be very reluctant to go along with this.

Last, and probably one of the most overlooked issues with taking the home, has to do with . . . taxes. Popeye and Olive bought their home for $500,000 a while back. Since the value has doubled, they would have a $500,000 gain if they sold the home today. Because it was their principal residence for two out of the last five years, they would be able to exclude all $500,000 of the gain from being taxed as a married couple (see IRS Publication 936 at www.opesadvisors.com/resource/links.html). But if Olive buys out Popeye and at some point in the future she sells the home, she will only be able to exclude $250,000 of the gain as a single person. This means she will take on about a $62,000 tax burden that she will realize when she sells the home (assuming the tax laws don’t change… so could be more!). Additionally, if Olive sells the property and pays a real estate commission, she will incur 100% of that expense, as opposed to splitting it with Popeye. This could easily be another $25,000 she would have otherwise not paid (50% of a $50,000 commission). Olive has now blown about $90,000, or 12% of the assets she received out of the divorce settlement, without even knowing it.

For those of you that are able, consider working to have your marriage not be the one-out-of-two that divorce. For the other half, seek out financial, tax and legal advice prior to settling the terms of your agreement. Your attorney may be very skilled in representing you legally, but unlikely to know all of the finance and real estate consequences to your decisions.

Copyright © Jeffrey T. Smith • (415) 464-9500 • jtsmith@opesadvisors.com Jeffrey T. Smith is a financial advisor and the Marin Manager for Opes Advisors, a Wealth Management Firm specializing in Mortgage Banking and Investment Management.

The value of your 401(k) is dependent on the tax rates when you withdraw money from it. Some think this will place restrictions on politicians in the future who want to raise taxes as all those owners of 401(k)’s will see the value drop with higher tax rates. Others are sure tax rates will have to go up because of the serious shortfalls in Social Security and Medicare. What this means is dependent on the individual but if you have a large 401(k) balance and that’s your primary retirement ticket, then you’ll probably want your representative to advocate for low marginal tax rates so the value of your 401(k) is there for you when you need it.
http://www.nytimes.com/2006/11/09/business/09scene.html

Thanks blmurch for the above photo.

There is a fantastic tax break for homeowners. You know the one – where you can deduct the interest and property taxes before calculating your income tax obligation. Here’s the thing: there are limits on how much and what you can deduct. We haven’t heard much about people getting into trouble, but the word on the street is the IRS is cracking down. If you’re not sure of the rules and limitations, read on so that you don’t end up sitting across the table from your friendly IRS auditor.With the disclaimer that you must seek tax advice from your CPA or tax preparer, let’s review generally what you are allowed to deduct. Simply put, if you own your principal residence or second home, and meet all of the conditions, you can deduct the interest and property taxes that you pay over the course of the year. Here’s an example: If a married couple had a 2006 adjusted gross income of $125,000, and spent $36,000 on qualified mortgage interest and real estate taxes, they calculated their income tax obligation based on $89,000 ($125,000 - $36,000). With a combined Federal & California marginal tax rate of about 34%, this couple received more than a $12,000 tax break.

So what’s the problem? Well, it’s not quite as simple as it may appear to meet all of the conditions for deducting the interest and property tax. Here are some of the hot topics and where we’re likely to see the crack down:

Qualifying Mortgage – You are generally allowed to deduct interest for your primary residence and second home if the mortgages (a) were used for the acquisition and/or substantial improvement of your home, (b) you are legally liable for the debt, (c) they are secured against your residence, and (d) they do not total more that $1 million. You are also allowed to deduct the interest on an additional debt of up to $100,000.

Let’s say that someone bought their home for $500,000 with $100,000 down and a 1^st loan for $400,000. After a few years, they took out an equity line for $100,000 to pay for things like a car, children’s college expense and some other things, using up the whole $100,000. Then more recently they decided to refinance for $600,000 (since their home was now worth closer to $1 million) and roll both loans into a new 1^st loan and pay off some other debts. They also have a new equity line for $200,000. Are they allowed to deduct all of the interest on the new $600,000 1^st loan and interest on the equity line? NO. And the IRS has made it a priority to investigate cases where they believe homeowners are taking mortgage interest deductions that are for loans greater than their acquisition debts.

Points – (a.k.a origination fee, discount points, etc.) This is considered pre-paid interest and is treated as such. One point equals 1% of the loan amount. If you pay points when you are purchasing your primary residence, you can usually deduct the full amount of the points in the year that you paid them. If you pay points on a refinance, you have to spread the deduction over the term of the loan (or typically 1/30^th each year on a 30-year loan).

I recently had a client who said that a lender offered to pay all of their closing costs (title insurance, escrow fee, appraisal, etc.). The lender required that they pay more points to get an equivalent interest rate (since the lender was going to pay for the closing costs). The loan officer suggested that they would be able to deduct the points. But the IRS states that in order to take the deduction, the points cannot be paid in place amounts that ordinarily are stated separately on the settlement statement, such as the “appraisal fees, inspection fees, title fees, attorney fees, and property taxes.”We’re just touching the metaphorical tip of the iceberg. There are a variety of things that will impact your ability to take home ownership deductions (Alternative Minimum Tax, 2^nd homes, businesses at home, etc.). For the down-and-dirty, read through IRS Publication 936 (available at www.opesadvisors.com/resource/links.html). Additionally, talk with your CPA and Financial & Mortgage Advisor. It’s a lot of money. Be wise.

Copyright © Jeffrey T. Smith