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Closing statement tips for new home buyers

HUD-1, also known as a closing statement and as a settlement statement
HUD-1, also known as a closing statement and as a settlement statement

Most closing agents will complete a Settlement Statement (HUD-1) (PDF) for the purchase of residential real estate (a residence). In NC closing agents are typically attorneys or paralegals under the supervision of an attorney. In many states, title companies and others can act as the closing agent (HUD calls them settlement agents).

There is some variety in how closing agents complete the HUD-1 which makes it more difficult for people to find what is and what is not deductible on their personal tax returns. This post will deal only with people purchasing a residence that will serve as their principal residence. Rental properties, commercial space, vacant land and second homes are treated somewhat differently or have additional considerations.

For the buyer

Keep in mind that only the amounts in the buyer column concern you unless otherwise noted.

Property taxes:

hud-1-tax-proration
HUD-1 tax allocation section

Lines 106 and 107 on page 1 are supposed to list your share of the real estate taxes for the current year/period that the seller already paid. You are reimbursing them for your share for the time you own the residence. You should be able to deduct these taxes on your Schedule A, if you itemize. From here forward, I am assuming you will itemize. In theory you will see the same amounts on lines 406 and 407 for the seller but sometimes the seller has not yet paid the tax and the closing agent will put the seller’s share on lines 510 and 511 and sometimes they do something else with the seller’s share.

If you do not see the taxes on lines 106 and 107, try looking on the lines below 107. The assessments on line 108 or seldom qualified real estate taxes. If you think they might qualify, find out more about them and then look at IRS Publication 17 for the definition of real estate taxes. If the seller has not yet paid the real estate taxes, look at lines 210 and 211 on page 1. This is the seller’s share of the real estate taxes you will pay on their behalf. They deduct this portion not the buyer. In this case, you take the total real estate tax you paid the year of closing on the new home and reduce them by this amount.

You may also find your share of real estate taxes on page 2 of the HUD-1. Most commonly they are listed on lines 808 to 811 or 1302 to 1305. Rarely I see them on other lines. You need to watch out for the amounts in the lender reserves/escrow section, lines 1001 to 1007.

Escrow section
Escrow section/Lender Reserves

These are deposits made with your escrow agent and are not deductible until paid to the tax authority. You can find what your escrow agent paid to the tax authority on your annual escrow reconciliation, on Form 1098 with your mortgage interest (not always there though), or on your monthly statements typically available online from your lender.

Interest:

When you purchase your principal residence, you can deduct reasonable charges for points and origination fees. You will almost always find them on page 2, lines 801 to 803. Sometimes the line 803 net is negative, meaning you chose a higher interest rate in exchange for lower closing costs. You do not get to deduct the negative amount because that is an amount the lender paid to you to cover other closing costs. You effectively deduct the negative amount via the higher amount you pay in interest as shown on your Form 1098. You do not need to track the negative amount. Points and origination fees paid by the seller are still deductible by the buyer. The theory is that the buyer paid them via a higher purchase price so you have to reduce your cost basis by origination fees and points paid by the seller. The IRS has endorsed this theory.

You may find some deductible interest on page 2, line 901. This amount plus the net points and origination fees are supposed to be on your annual Form 1098 from your mortgage company. Sometimes they are not because the total is under $600 and the mortgage company is not required to issue a Form 1098 in that case. This usually happens when the mortgage company sells the loan immediately to another lender or when you close near the end of the year. Sometimes your Form 1098 is wrong and omits part or all of the deductible origination fees, points and interim interest. You need detail from the mortgage company on how they calculated the amount on Form 1098 to see if they missed the interim interest from line 901.

Mortgage insurance premiums:

On page 2 you want to again ignore the line 1003 escrow amounts. These are on deposit for you until paid and should show on your Form 1098 once paid to the insurance company. However, make sure the amount on line 802 is reported on your Form 1098. If not, you may be able to deduct it depending on the rules for the year you buy. Congress cannot make up its mind about this deduction and it expires quite often only to be later renewed. Who can deduct mortgage insurance premiums is income based and depends on the year the loan was opened.

That is it for buyers. Sorry, the prorated homeowner association fees, prorated utility bills, homeowner’s insurance, title charges, recording fees and other loan fees are not deductible on a principal residence. Some of these charges, such as the title charges and deed recording fees, are added to your cost but not immediately deductible.

Sellers

Property taxes:

This is very similar to the above section for buyers on property taxes except you are only interested in the amounts in the seller column.

Interest:

You should look at your Form 1098 to find the mortgage interest you paid. Sometimes this amount is wrong if you used a relocation company when your employer pays for your move. The relocation company may hold onto your house and pay your mortgage for several months after you “sell” it to the relocation company. You only get to deduct the interest you pay, not that paid by the relocation company. A history of the payments for the year can help you figure out your share.

Mortgage insurance premiums:

Sorry, these are for the buyer’s benefit. The seller cannot deduct them as an itemized deduction even if the seller pays them.

Cost of selling

Assuming you do not get to exclude your entire gain from your income taxes (see Schedule D instructions for details), you will need to know the costs of selling you can deduct. Typically, you can deduct everything you paid except your share of real estate taxes, the payoffs of mortgages and other debts, and operating costs (ex. utility bills, repairs, homeowner’s association fees, etc.). Some examples are the real estate commission, title charges, and closing costs for the buyer (ex. you paid part of the buyers points). If you sell through a relocation company, look at your settlement statement with them and not the settlement statement between them and the buyer.

As most people can exclude the gain from selling their house, I have kept this section brief. If you will owe tax on some or all of the gain you will need to check with a tax professional or do more reading.

Conclusion

Most people do not have a lot of experience reading HUD-1 settlement statement. I hope this post helps you find the itemized deductions your are entitled to. Keep in mind that there are other limitations and rules regarding how much mortgage interest and mortgage insurance premiums you can deduct. This post is already long, so I have not covered them here.

I hope you are enjoying your new home and will have many happy years there.

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When is alimony not deductible alimony?

Bottle of Alimony Ale
Alimony Ale by Johan Kuno, under Creative Commons license, on Flickr

When the tax law says it isn’t deductible alimony!

Just because you agree with your ex-spouse and/or the judge orders alimony does not mean it is alimony for tax purposes. Congress put in specific requirements for a payment to qualify as alimony for income tax purposes. The IRS does not care what the judge, the divorce agreement or the separation agreement calls the payment, except in one situation explained below.

Requirements to be deductible alimony

The seven requirements are:

  1. The payment must be in cash. A check or bank transfer works also. There is a little wiggle room here. If the payer is required to pay third parties (e.g. housing costs, but they do not count if the payer is on the loan or deed) on behalf of the separated spouse or ex-spouse then the payment can count as paid in cash. The payments to third parties needs to be required by the written agreement. As an alternative, the spouses can agree in writing to treat a third-party payment as alimony. Get it signed.
  2. The alimony must be in a written agreement or court decree. The agreement needs to be signed by both parties. A written separation agreement works, a verbal separation agreement does not.
  3. The agreement cannot have a clause agreeing to treat the alimony as not alimony for tax purposes. Yes, Congress allows the spouses to agree that the alimony is not alimony with no deduction for the payer and no additional income to the recipient.
  4. The payments must terminate at the death of the payee (recipient). While state law may save you if your document is silent, it is best to make sure the written agreement or court order says the payments stop at the payee’s death.
  5. The spouses must not live together at the time of the payments.
  6. The spouses, while separated, must not file a joint return.
  7. The payments must not be reduced or stopped based on a contingency relating to a child. For example, if the payments stop when the child reaches age 18 then the payments are not alimony for tax purposes.

There is a separate rule that can make the alimony retroactively cease to be alimony. This happens when the payments are front loaded in the first year or two and then drop in year three. You can find the details in IRS Publication 504 (downloads as PDF).

One more thing, if the payer is unable to pay total due for child support and alimony, then the law treats the payment as for child support first.

Conclusion

So do not drink that Alimony Ale while reading your divorce or separation agreement. Save that for later after you are sure you are getting the tax results you desire.

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Year-end tax planning – part 3

U.S. Currency - Wikimedia Commons
U.S. Currency – Wikimedia Commons

Here are some final year-end tax planning ideas for 2014.

Some of these items are more for 2015 than 2014 but now is the time to put them in place.

  1. If you have a Health Savings Account (HSA) available, maximize your contribution for 2015. Unlike Flexible Spending Accounts (FSA), you do not lose the amount in a HSA that is not used by the end of the contribution year. Some FSAs have been amended to allow a full carryover for two months and 15 days into the next year or a carryover of a maximum of $500. This is an either or option – either the plan allows the carryover of unused FSA money of no more than $500 to the next year OR it allows a two month and 15 day grace period into the next year to allow the use of the rest of the FSA balance.
    A HSA allows you to carryover the entire balance as long as you live.
  2. If you own your own business and want to establish a 401(k) plan for 2014, the deadline is 12/31/2014. Of course, waiting until now severely limits your ability to have much withheld from your pay for 2014 employee contributions. Setting it up now gets you ready for 2015 and it still allows an employer contribution to the 401(k) plan for 2014.
  3. If you miss the deadline for establishing a 401(k) for your business for 2014, do not forget that a SEP plan can be established up to the deadline for filing your 2014 return.
  4. If you are harvesting tax losses and reinvesting the proceeds, consider investing in more tax efficient investments. Mutual funds and ETFs that trade actively generally generate more ordinary dividends and capital gains than the invest and hold funds. Index funds are often more tax efficient than actively managed funds.
  5. Again, if you sell some investments before year-end to harvest the tax losses then consider investing some of the proceeds in tax-exempt bonds, mutual funds or ETFs. If your income tax rate is relatively low, you need to consider whether the tax savings makes sense considering the lower interest tax-exempt investments usually return. Also keep in mind that if interest rates start to go up, the value of tax-exempt bonds, mutual funds and ETFs go down in value as rates increase.
  6. If your employer does not provide qualifying ACA (aka Obamacare) health insurance then consider obtaining a qualifying health plan so you can avoid a 2015 penalty. The penalty increases for 2015 over what it is for 2014.
  7. Take 529 education plan distributions in the same year as the qualified education expense. Most colleges and universities like to be paid in December for the following spring semester or quarter. If you or your child happens to be graduating in the spring, they may not have enough qualifying expenses to make a spring 529 plan distribution tax-free.
  8. Consider a Roth IRA contribution for your children if they otherwise qualify. A Roth allows no deduction but qualified withdrawals are tax-free unlike regular IRA contributions that are generally taxable. If your child’s only income is wages of $4,000 or less, they probably will not owe any federal income tax so not being able to deduct the Roth contribution is no big deal. Your child has until April 15, 2015 to make a Roth IRA contribution for 2014.

Do you have any favorite tax planning ideas I forgot? Please add them in the comments.

You can also see part 1 and part 2 in the year-end tax planning posts.

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Year-end tax planning – part 2

Tax Deductions
Tax Deductions by Chris Potter, on Flickr

Accelerate deductions

Assuming your tax rates are the same or higher this year than they will be next year, then you should consider accelerating deductions into this year.

If you are on the cash basis, almost all individuals are, then you can prepay deductible items that are due next year. For example:

  • Real estate taxes, in NC they are generally not late until after January 5th of next year but is it really worth waiting an entire year for the deduction to keep the money for five days?
  • Personal property taxes.
  • Charitable contributions.
  • Final state and local estimated tax payments that are traditionally due in January of the next year.
  • Pay outstanding medical bills if you will be able to itemize medical deductions (usually only amounts in excess of 10% of your adjusted gross income are deductible).
  • Pay your January home mortgage payment early. Make sure the mortgage company gets it before the end of the year so they credit it to the year you paid.
  • If you are in business, consider:
    • Buying assets subject to the Section 179 deduction. Currently, the limit is a maximum of $25,000 but Congress is considering changing the limit. Eligible assets are typically tangible personal property but the rules are complex. Check first to see if the asset is eligible as getting a refund from the seller may be difficult. There are other limits to keep in mind too that are not detailed here.
    • Pay year-end bonuses this year that are due in January of next year. Bonuses are still wages and subject to withholding taxes when paid to an employee.
    • Stock up on office supplies.
    • Prepay part of next year’s rent. Do not go overboard, only up to twelve months prepaid is deductible.
    • Complete repairs (not improvements) and pay for them this year.

Other options:

  • Sell capital assets (e.g. stocks, mutual funds, and bonds) at a loss to offset capital gains and net a loss of $3,000 that can be deducted against other income. Watch out for the wash sale rule. This rule postpones losses if you buy the same or a similar asset (e.g. an option on the stock you sold) within 30 days before or after the loss sale date. For some people it is best to pretend it is 31 days as IRS does not forgive you for counting the days wrong.
  • If you pay off your credit card balance every month, consider using your credit card to pay your deductions. There is no tax advantage in using a credit card versus paying in cash. The advantage comes from getting the deduction when the charge goes through versus when the payment is made to the credit card company next year. If you carry a balance on your credit card (i.e. you pay interest) then this option is much less attractive and may be cost more in interest than it saves in taxes.
  • Businesses on the accrual method of accounting cannot generally accelerate deductions by paying them early. For example, an accrual business gets no benefit from paying this year for inventory to be received next year. The prepayment is treated as non-deductible deposit. Accrual businesses can take advantage of the Section 179 deduction and they have other options.

Keep in mind that if you claim the standard deduction instead of itemizing, accelerating deductions may not make much sense. Instead you should consider bunching itemized deductions into one year so that you can itemize and claiming the standard the next year (or vice versa – standard this year then bunch next year).

Finally, keep in mind that tax planning is a multiple year process. Saving tax this year at the cost of even more tax next year does not make sense. Also, be aware that if you owe Alternative Minimum Tax or are close to owing then accelerating some deductions, such as taxes, may not save any federal tax.

Most important

Do not allow the “tax tail to wag the dog.” In other words, the most important thing is how much you have after taxes. For example, a contractor should not buy a new generator just for the tax deduction when her old generator works just fine. The tax savings are less than the cost of the new generator.

Year-end tax planning part 1 is available here and pat 3 is here.

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Year-end tax planning – part 1

U.S. Currency - Wikimedia Commons
U.S. Currency – Wikimedia Commons

Income deferral

Deferring income into the next year is one of the most common year-end tax planning devices. The idea is to push the income into a future year when your tax rates will be lower. Even if your tax rates will not be lower next year, deferring income still makes sense as long as your rate next year will not be higher. As long as the tax rates are the same, paying in the future is usually better than paying today.

How do you defer income? Here are some possibilities:

  1. Sell stocks, mutual funds, bonds, and other capital assets that have gains next year instead of this year.
  2. Do not buy a mutual fund between now and the end of the year as mutual funds typically pay out any capital and ordinary gains in the last month of the year.
  3. If you are self-employed and your business is on the cash basis, delay billing your customer(s) until closer to the end of the year or next year. Do not abuse this tactic. If your customer offers to pay you this year and you get them to hold the payment without a good business reason (i.e. a reason unrelated to taxes) then IRS will consider you to have received the income this year. IRS may also question delayed billings if you put it off too long. If you typically bill within 15 days of completing a job and decide to wait six months to defer the income, IRS can ignore the deferral. They will make the the argument that your customer would have paid before year-end if you billed them in a normal time frame. One way around this is to arrange the payment terms BEFORE you start the job (e.g. make it part of the contract terms).
  4. Do not exercise non-qualified stock options until next year. Watch out, do not let an in the money option expire just to save some tax. Some after tax income is better than none.
  5. Ask your employer about the possibility of a non-qualified deferred compensation plan. This is more for next year as the deferral has to be in place before the beginning of the year to which it applies. Be careful with this tactic as you can lose the deferred compensation if your employer goes bankrupt. The non-qualified part means the deferral is not subject to the normal protections provided to employer pension plans.
  6. Defer as much as possible into your retirement plans – 401(k), 403(b), etc.

Unfortunately, Congress has made planning difficult because of the Alternative Minimum Tax and all the phasing out of deductions and credits. So postponing income into next year may cost you a tax credit, deduction or increase your Alternative Minimum Tax in the future. When you plan, always consider the effect to both this year and future years.

Most important

Do not allow the “tax tail to wag the dog.” In other words, the most important thing is how much you have after taxes. For example, if the stock you want to sell has a big gain now, consider the cost of waiting to sell next year when its price may have dropped significantly.

You can now read part 2 and part 3.