THE TAX ADVANTAGES OF HOME OWNERSHIP

Congress has recently enacted the Energy Policy Act of 2005, the Tax Relief and Health Care Act of 2006, and the Pension Protection Act of 2006. These Acts have numerous tax planning considerations which can affect you. Unfortunately, many of the benefits are only temporary. The following is a brief synopsis of some of the more fundamental tax rules that affect real property transactions including the new tax changes.

ENERGY EFFICIENT HOME CREDITS:

There are new tax credits for making your home energy efficient in 2006 or 2007. You can reduce your taxes by 30% of the cost of photovoltaic or solar water heating equipment, up to a $2,000 credit for each, and by 30% of the cost of a fuel cell power plant, up to a credit of $500 for each 0.5 kilowatt of capacity. You can get these credits as many times as you buy these types of equipment for your residence in 2006 and 2007. In contrast, there is a "lifetime" credit of up to $500 for making specified energy saving improvements to your principal residence. These improvements include: insulation, exterior windows and skylights, exterior doors, and metal roofs. The credit on these improvements is 10% of the cost, with a $200 credit limit on windows. The $500 lifetime cap also includes up to $300 of the cost of heat pumps, water heaters and air conditioners, meeting certain standards, up to $150 for furnaces, and up to $50 for an advanced main air circulating fan. Unfortunately, these credits expire at the end of 2007 (unless extended by Congress).

PRIMARY HOME SOLD, GAIN EXCLUSION:

If you owned your primary residence for at least two of the last five years and then sold it, up to $250,000 in profit is tax-free for single taxpayers. Married couples have $500,000 in tax-free gain from a qualifying home sale. The two-year occupancy need not be continuous. Only one spouse need be on title but both must meet the residency requirement. Be sure to read "How Do You Determine Cost Basis On Your Home?" for additional important considerations when computing the gain/loss on your home. Note, the tax authorities use a double standard. They are happy to tax you on the gain of any personal assets sold (including your home) however, any loss on sale of personal assets is not deductible. Also, there is no requirement that you buy a new home. Even if you do buy a new home, the purchase of the new home will not affect the possible tax liability of the old home sale. (Note: IRC 1031 deferred exchanges are not allowed for personal assets such as your home, only "investment" property qualifies for a deferred exchange).

DIVORCED OR SEPARATED SPOUSES:

As a general rule, no gain or loss is recognized on inter-spousal title transfers during marriage or divorce. However, an exception is made in cases where the spouses agree to delay the sale of their primary residence. For the welfare of the children, a divorce decree may allow one spouse to reside in the home until some time in the future when the property will be sold and the proceeds divided equally. If the resident spouse qualifies for the $250,000 home sale exemption, the non-resident spouse also qualifies for the $250,000 home sale exemption.

SURVIVING SPOUSE:

The widow may claim the $500,000 exemption if the home is sold during the year the spouse died. If the surviving spouse inherits the deceased spouse's half of the residence, the adjusted cost basis on the inherited half is usually "stepped-up" to market value on the date of the death, thus reducing the surviving spouse's taxable gain upon sale. In California, as a community property state, the surviving spouse can usually claim a new stepped-up basis on the home's entire market value, thus resulting in little or no tax upon sale.

HOUSE PARTNERS:

Unmarried co-owners who sell their primary residence after two years may each claim the $250,000 exemption. Up to four co-owners can qualify and individually claim the exemption for the million dollars tax-free. This is quite an incentive for individuals to find a property with the potential to yield a million dollar tax-free profit after two years of residency.

PERSONAL RESIDENCE EXEMPTION:

As long as the taxpayer meets the two-year residency requirement for each sale, the individual $250,000 and the married couples $500,000 tax exemptions can be claimed every two years. If you have the ability to pick the right properties and the stamina to live in multiple houses (some undergoing remodeling and construction), this might be a beneficial way to accumulate tax-free income.

SECOND HOME:

Unless you use a vacation property or second home as your primary residence, the sale of the property probably will not satisfy the occupancy requirement and also not qualify for the special $250,000/$500,000 home sale tax exemption. Many people have moved into their second home (or rental) for the required two years, then sold it to take advantage of this law. If you have a second home you now want to sell, be sure to speak with a tax accountant before taking any other action. Be sure to pre-plan this with your tax advisor. Congress has created new obstacles which must be reviewed and considered.

DID YOU BUY YOUR HOME LAST YEAR? DEDUCT THE POINTS:

If you bought a home in 2006, you may deduct some of the costs associated with your home loan or acquisition mortgage. Did your lender quote an interest rate plus points for the loan? A point equals one percent of the loan amount. Check your escrow closing statement for the amount of the loan fee or points as that amount qualifies as an itemized deduction. Most times the points and interest are already reported on the annual Form 1098.

If you obtained a home loan in 2006 that you used to make improvements to your home, the points are also deductible. With either a purchase or home improvement loan, you may have been charged a prorated interest amount for the month you closed escrow. Check your closing statement for this deduction (although it is typically included/reported on your annual Form 1098)

If you simply refinanced the loan on your home or borrowed against other real property to take cash out or secure a lower interest rate, the points or loan fees must be deducted annually over the life of loan. For instance, a 30-year loan for $250,000 with one point, or $2,500, should be deducted at $83.33 per year for each of 30 years, or until the loan is repaid.

If you refinanced prior to 2006 and forgot to deduct the points, you can start taking the deduction over the life of the loan on this year's return.

HOME INTEREST DEDUCTIONS:

An important reminder is that only loans which are secured to the home (or a second home) are generally deductible. Equity loans from a rental which are used to purchase or improve your home are not deductible because the loan is not secured to your primary home (or second home). In addition, not all home interest is deductible. For example, home equity loans might be deductible for regular tax purposes, but if the loan proceeds are not used for home improvements, the interest expense is not deductible for Alternative Minimum Tax (A.M.T.) purposes. Also, home interest deductions for a boat or motor home may be deductible for regular tax purposes but are not deductible home interest for A.M.T. purposes. Be sure to see your tax advisor.

PROPERTY TAX:

Property tax is payable in two installments due November 1, 2006 and February 1, 2007. If you have an impound account with your lender, the IRS annual form 1098 may also identify the amount of property tax paid in 2006. If you prepay the February 2008 property tax installment by December 31, 2007, you will accelerate additional property tax deductions into 2007, which may reduce your 2007 taxes, (but check with your tax advisor).

If you bought property last year, escrow prorates the portion of property tax paid by the seller. Your closing statement may reflect a property tax charge (additional tax deductions) from the date you took title to the property and the seller would have received a corresponding credit. However, if you agreed to pay the property tax owed by the seller, you could not claim that amount as a deduction; instead you add it to your cost basis of the property.

Supplemental property tax payments are deductible for the tax year in which they are paid. There may be delays in placing supplemental assessments on the tax rolls. If you purchased a home in the last half of 2006, the increase in assessed value might not be placed on the tax roll until after January 1, 2007, in which case you will receive a second supplemental tax bill in 2007.

-Reassessment

Caution: more and more counties are reassessing the property taxes when the owners of real estate corporations, parnterships, LLC's transfer (sell or trade) their ownership but there was not a change in the real estate title.

-Prepayment

Many investors who are looking for more tax deductions are prepaying their next year's property tax in the current year. For example, paying the April 10, 2008 property tax bill in December 2007 will shift the timing of the tax deduction to the 2007 tax year.

LOAN PREPAYMENT PENALTY:

If you paid off an existing real property loan in 2006 and were charged a prepayment penalty, that prepayment penalty is tax-deductible as it is an additional interest payment. Remember to deduct the interest amount if you prepaid your January 2007 home loan payment at the end of 2006. If you assumed an existing loan, you may deduct any prorated interest charges for the month the sale closed escrow (although this is typically included in the IRS annual Form 1098). Construction loan interest and property taxes are also deductible for a primary residence that will be completed and occupied within two years.

DID YOU CHANGE JOBS AND RELOCATE IN 2006?

A homeowner or renter can deduct almost all of their moving costs if their new job location is at least 50 miles further from their old home than their previous job. For example, if it was 5 miles from your old home to work at your old job and the new job is 60 miles from your old home, you meet one of the requirements (60 - 5 = 55 miles). The second requirement is that you work at least 39 weeks of the next year in the vicinity of your new job location (an additional 39 weeks in the second year are required for self-employed persons). You do not need to itemize deductions to take advantage of the moving cost tax adjustment. The distance from your new home to your new job is not a consideration.

HOW DO YOU DETERMINE COST BASIS ON YOUR HOME?

Basis is your starting point for figuring a gain or loss if you later sell your home, or for figuring depreciation if you later use part or all of your home for business purposes or for rent. While you own your home, you may add certain items to your basis. These items are called adjustments to basis.

It is important that you understand these terms when you first acquire your home because you must keep track of your basis and adjusted basis during the period you own your home. You must also keep records (i.e. cancelled checks) of the events that affect basis or adjusted basis.

-Figuring your basis

How do you figure your basis depends on how you acquire your home. If you buy or build your home, your cost is your basis. If you receive your home as a gift or from a (former) spouse, your basis is usually the same as the adjusted basis of the person who gave you the property. If you inherit your home from a decedent, the fair market value at the date of the decedent's death is generally your basis. IRS Publication 551, Basis of Assets, gives more information including examples of figuring your basis when you received property as a gift. IRS Pub 504, Divorced or Separated individuals, discusses transfers between spouses. You can find and read these publications at http://www.irs.gov.

-Fair market value

Fair market value is the price that property would sell for on the open market. It is the price that would be agreed upon between a willing buyer and a willing seller, with neither having to buy or sell, and both having reasonable knowledge of the relevant facts. The fair market value does not affect your cost basis.

-Cost as basis

The cost of your home also includes most settlement or closing costs you paid when you bought the home. If you built your home, your cost includes most closing costs paid when you bought the land or settled on your mortgage.

-Purchase

The basis of a home you bought is the amount you paid for it. This usually includes your down payment and any debt you assumed. The basis of a cooperative apartment is the amount you paid for your shares in the corporation that owns or controls the property. This amount includes any purchase commissions or other costs of acquiring the shares.

-Construction

If you contracted to have your home built on land that you own, your basis in the home is your basis in the land plus the amount you paid to have the home built. This includes the cost of labor and materials, the amount you paid the contractor, any architect's fees, building permit charges, utility meter and connection charges, and legal fees that are directly connected with building your home. If you built all or part of your home yourself, your basis is the cost of materials you bought. You cannot include the value of your own labor or any other labor you did not pay for. Be sure to keep your cancelled checks.

-Adjust basis

The table below summarizes items that will generally increase or decrease your basis in your home:

Increases to basis-

Improvements:
-Putting an addition on your home.
-Replacing an entire roof.
-Paving your driveway.
-Installing central air conditioning.
-Rewiring your home.
-Assessments for local improvements.
-Amounts spent to restore damaged property.

Decreases to basis-

-Insurance or other reimbursement for casualty losses.
-Deductible casualty loss not covered by insurance.
-Payment received for easement or right-of-way granted.
-Depreciation deduction if home is used for business or rental purposes.
-Value of subsidy for energy conservation measure excluded from income.

-Closing costs

If you bought your home, you probably paid settlement or closing costs in addition to the contract price. These costs are divided between you and the seller according to the sales contract, local custom, or understanding of the parties. If you built your home, you probably paid these costs when you bought the land or settled on your mortgage. The only closing costs you can deduct are home mortgage interest and certain real estate taxes. You deduct them in the year you buy your home if you itemize your deductions. You can add certain other settlement or closing costs to the basis of your home.

-Items added to basis

You can include in your basis the settlement fees and closing costs you paid for buying your home. The following are some of the settlement fees and closing costs that you can include in the original basis of your home:

-Charges for installing utility services.
-Legal fees (including fees for the preparation of the sales contract and deed).
-Recording fees.
-Surveys.
-Transfer taxes.
-Title insurance.
-Any amount the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, cost for improvements or repairs, and sales commissions.

If the seller actually paid for any item that you are liable for and that you can take a deduction for (such as your share of the real estate taxes for the year of sale), you must reduce your basis by that amount unless you are charged for it in the settlement.

Here are some settlement and closing costs that you cannot deduct or add to your basis:

-Fire insurance premiums.
-Charges for using utilities or other services related to occupancy of the home before closing.
-Rent for occupying the home before closing.
-Charges connected with getting or refinancing a mortgage loan such as:
a. FHA mortgage insurance Premiums & VA funding fees.
b. Loan assumption fees.
c. Cost of a credit report.

-Improvements

An improvement materially adds to the value of your home, considerably prolongs its useful life, or adapts it to new uses. You must add the cost of any improvements to the basis of your home. You cannot deduct these costs in the year paid, only in the year sold. Improvements include putting a recreation room in your unfinished basement, adding another bathroom or bedroom, putting up a fence, putting in new plumbing or wiring, installing a new roof, paving your driveway, etc.

-Amount added to basis

The amount you add to your basis for improvements is your actual cost. This includes all costs for material and labor, except your own labor, and all expenses related to the improvement. For example, if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence. You must also add to your basis state and local assessments for improvements such as streets and sidewalks if they increase the value of the property. These special tax assessments are not considered a property tax deduction and should not be deducted as a property tax. Instead they are assessments for improvements on your property and therefore added to the basis of your home. Your tax preparer should be tracking these additions to basis.

A repair keeps your home in an ordinary, efficient operating condition. It does not add to the value of your home or prolong its life. Repairs include repainting your home inside or outside, fixing your gutters or floors, fixing leaks or plastering, and replacing broken windowpanes, etc. You cannot deduct repair costs and generally cannot add them to the basis of your home. However, repairs that are done as part of an extensive remodeling or restoration of your home are considered improvements. You add them to the basis of your home.

RECORDS TO KEEP:

You must keep records relating to the basis of the property longer than the statute of limitations. Keep those records as long as they are important in figuring the basis of the original or replacement property. Generally, this means for as long as you own the property and, after you dispose of it, for the statute of limitations that applies to you.

ENERGY CONSERVATION SUBSIDY:

If a public utility gives you (directly or indirectly) a subsidy for the purchase or installation of an energy conservation measure for your home, do not include the value of that subsidy in your income. You must reduce the basis of your home by that value.

An energy conservation measure is an installation or modification primarily designed to reduce consumption of electricity or natural gas or to improve the management of energy demand.

CALIFORNIA STATE INCOME TAX WITHHOLDING ON PROPERTY SALES:

Tax withholding is mandatory on all sales of California real property. The withholding rate is 3.5 percent. Exceptions to the withholding rules include:

-Sales price is not greater than $100,000.
-Property is the seller's principal residence.
-Sale is part of 1031 tax-free exchange of 1033 involuntary conversion transaction.
-Seller certifies that sale will result in a loss for California tax purposes.
-Certain foreclosure transactions.

There are also specific provisions relating to installment sales. The law states that withholding will be required by the buyer on each installment payment received.

The new law does not contain language allowing for requests for either a waiver of withholding or reduced withholding for individuals as currently allowed under CAL FIRPTA.

As under the current CAL FIRPTA rules, it will be escrow's responsibility to inform the principals of the withholding requirements. The maximum charge for providing assistance remains at $45.00 per seller.

There are two options available to the buyer (withholding agent) in the case of installment sales (seller carrybacks): all the withholding is done up front at the time of closing or the buyer remits withholding on a monthly basis as payments are made to the seller. The withholding is based on the total payment made.

CAN YOU CLAIM A HOME OFFICE?

There are four key tests that you must meet in order to qualify for the home office deduction.

Small Business / Self-Employed Home Tests:

1. Exclusive Use: To qualify for this test, you must have a specific area of your home used only for the business. The area used can be a room or other space identified as separate, but the area must be used solely for business. For example, if you have a room set up as an office, but occasionally use it also as a guest room, you do not meet this test. Likewise, if the area is used to handle personal finances or homework, you do not meet this test. In order to meet this test, you must use the area solely for the business.

2. Regular Use: In order to meet this test, you must use the specific area on a continuing basis. If it is used only occasionally, you don't meet this test. However, in the construction industry it is typical to have a slow period during the winter months. As long as the area is still set aside and not used for any other purpose, the slow down of the business would not prevent you from meeting this test.

3. Business Use: As in the previous example, if you are actively operating your construction business, you will meet this test.

4. Place of Business: The last test requires that your home office is either your principal place of business or the place you regularly meet with customers. To meet this test, your home office must be your principal place of business. In the construction industry, your business location may be split between two places: the job site and the place you keep your records. As long as you use the area exclusively and regularly for the administrative or management activities of your business, and you have no other fixed location where you conduct these activities on a substantial basis, your office will qualify.

Example:

Sam is a self-employed bricklayer. His only office is a room in his home, which he uses regularly and exclusively to phone customers, decide what supplies to order, bill customers and pay expenses of the business. Sam meets the four tests: exclusive use, regular use, business use, and use of the home office for the administrative activities of the business.

-Place You Regularly Meet With Customers

If you regularly meet or deal with customers in your home, you can deduct your expenses for the home office even if you have another office. Occasional meetings and telephone calls do not meet this test.

Example:

Tyler is a self-employed electrician. He rents office space where his bookkeeper works. He also has a dest at his home where phone calls are forwarded from the office after hours for occasional emergency calls. Although Tyler receives some work calls at home, he does not meet this test.

-Seperate Structures

If you have a separate structure and you use it exclusively and regularly for your business, you may deduct the expenses related to the structure whether or not you can deduct your home office expenses. These expenses could include:

-Utilities
-Depreciation allowed on the furnishings
-Depreciation allowed on the structure
-Repairs

Example:

Adam is a self-employed roofer. He has a home office where he keeps his books and records. Adam also has a storage shed in his backyard that he uses only to store the tools used in the business. Adam can deduct the expenses directly related to the storage shed and the expenses for his home office.

Example:

Ben is a self-employed painter. He rents office space where his bookkeeper works and he meets with contractors. He also has a storage shed in his backyard, which he uses only to store the tools and supplies used in his business. Although Ben does not have a home office, he can still deduct the direct expenses related to the shed.

Remember that when the home is sold at a gain, you will have to pay tax on prior depreciation deductions you took for your home office (this is referred to as depreciation recapture). The gain on sale of home exclusions above does avoid the taxability of the depreciation recapture on a home office. Also, these home office deductions are only allowable if you have business net income to offset it.

ELECTION TO EXPENSE CERTAIN DEPRECIABLE BUSINESS ASSETS:

This is probably the most popular tax deduction used by individuals who own their own business. According to IRC Section 179 - Business are able to expense in the year of acquisition up to $108,000 of new or used personal property acquired in tax years beginning in 2006 (subject to additional restrictions). This amount will be indexed for inflation for tax years beginning in 2007 and 2008. Also, this special depreciation deduction is only allowable if you have business net income to offset it. IRC section 179 is generally not available for rental real estate.

ARE YOU PLANNING TO SELL BUSINESS OR INVESTMENT PROPERTY?

Before selling a property, calculate whether any passive losses you have carried over would offset the gain you will realize on the property. Sometimes you may find it is better to sell a rental property to free up cash than to sell stocks or refinance, due to passive loss carryovers and non-tax factors.

If you will have a taxable gain because you sell real "investment" property held as an investment or used for your business, consider the advantages of a 1031 Tax Deferred Exchange. An exchange can defer or even eliminate income taxes on the gain, while allowing you to reinvest the proceeds into another like-kind property. An exchange has to be planned for before the property is even listed, due to the exacting tax laws that have to be followed to the letter. The laws include a requirement that a third party hold the proceeds between the sale of your current property. Be careful, any cash you touch becomes taxable. Some companies have set up syndications that accept deferred exchanges from many owners, then purchase a large property, to give owners a greater economic benefit with less personal management. These are called Tenant-in-Common (TIC) investments.

Installment sales are a way of spreading taxable gains over several years. Calculations must be done before a sale is finalized. However, as depreciation recapture can be fully taxed in the first year, this could mean possibly lots of tax and no cash to pay it!

Exchanges, installment sales, and the personal residence exemption could be combined to obtain the tax effect you want. If using an exchange to convert a rental gain to a personal residence gain, you need to own the new home for five years before you can claim the exemption.

RETIREMENT PLANS:

IRAs can invest in real estate under certain rare circumstances. An IRA cannot invest in a home you live in. Income taxes can be due if the IRA buys a property with a mortgage. As IRAs have to be held by a trustee approved by the IRS, look for one that will allow your IRA to invest in real estate.

-IRA used to make a contribution

Congress recently also passed the Pension Protection Act of 2006. This Act allows individuals who are over age 70.5 to make contributions up to $100,000 to qualified charities from their IRA (a traditional or rollover IRA). These withdrawals also count towards the individual's Required Minimum Distributions. In addition, the withdrawal is not reported on the individual's tax return (which could reduce his/her taxable income because the Required Minimum Distribution is not required to be added to the tax return if it was paid directly to a qualified charity). This withdrawal is only allowed in years 2006 and 2007.

This brochure is provided for general information only. Please consult your tax or legal advisor to determine if any of the material applies to your specific circumstances.