What’s so attractive about a Roth IRA? Here’s a summary: 

• Earnings within the account are tax-sheltered (as they are with a regular qualified employer plan or IRA).
• Unlike a regular qualified employer plan or IRA, withdrawals from a Roth IRA aren’t taxed if some relatively liberal conditions are satisfied.
• A Roth IRA owner does not have to commence lifetime required minimum distributions (RMDs) after he or she reaches age 70 1/2 as is generally the case with regular qualified employer plans or IRAs. (For 2009, there’s a moratorium on RMDs.)
• Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings (as with a regular qualified employer plan or IRA) and tax-free withdrawals (unlike with a regular qualified employer plan or IRA). They do, however, have to commence regular withdrawals from a Roth IRA after the account owner dies.

The catch, and it’s a big one, is that the rollover will be fully taxed, assuming the rollover is being made with pre-tax dollars (money that was deductible when contributed to an IRA, or money that wasn’t taxed to an employee when contributed to the qualified employer sponsored retirement plan) and the earnings on those pre-tax dollars. For example, if you are in the 28% federal tax bracket and roll over $100,000 from a regular IRA funded entirely with deductible dollars to a Roth IRA, you’ll owe $28,000 of tax. So you’ll be paying tax now for the future privilege of tax-free withdrawals, and freedom from the RMD rules.

Should you consider making the rollover to a Roth IRA? The answer may be “yes” if: 

• You can pay the tax hit on the rollover with non-retirement-plan funds. Keep in mind that if you use retirement plan funds to pay the tax on the rollover, you’ll have less money building up tax-free within the account.
• You anticipate paying taxes at a higher tax rate in the future than you are paying now. Many observers believe that tax rates for upper middle income and high income individuals will trend higher in future years.
• You have a number of years to go before you might have to tap into the Roth IRA. This will give you a chance to recoup (via tax-deferred earnings and tax-deferred payouts) the tax hit you absorb on the rollover.
• You are willing to pay a tax price now for the opportunity to pass on a source of tax-free income to your beneficiaries.

You also should know that Roth rollovers made in 2010 represent a novel tax deferral opportunity and a novel choice. If you make a rollover to a Roth IRA in 2010, the tax that you’ll owe as a result of the rollover will be payable half in 2011 and half in 2012, unless you elect to pay the entire tax bill in 2010.

Why on earth would you choose to pay a tax bill in 2010 instead of deferring it to 2011 and 2012? Keep in mind that absent Congressional action, after 2010 the tax brackets above the 15% bracket will revert to their higher pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31%, and 28%, instead of the current top four brackets of 35%, 33%, 28%, and 25%. The Administration has proposed to increase taxes only for those making $250,000, but it is difficult to predict who will get hit by higher rates. What’s more, there’s a health reform proposal before the House of Representatives right now that would help finance healthcare reform with a surtax on higher-income individuals.

So if you believe there’s a strong chance your tax rates will go up after 2010, you may want to consider paying the tax on the Roth rollover in 2010.

Here are some ways individuals can prepare now for next year’s rollover opportunity.

(1) Non-high-income individuals who are able to make deductible IRA contributions this year should do so. They’ll reduce their 2009 tax bill and, if they make the conversion to Roth IRA next year, they won’t have to pay back the tax savings until 2011 and 2012.

(2) Individuals who have never opened a traditional IRA because they weren’t able to make deductible contributions (and who never rolled over pre-tax dollars to a regular IRA) should consider opening such an IRA this year and making the biggest allowable nondeductible contribution they can afford. If they convert the traditional IRA to a Roth IRA next year they will have to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened, presumably a small amount. In 2010 and later years, they could continue to make nondeductible contributions to a traditional IRA and then roll the contributed amount over into a Roth IRA. However, note that if an individual previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.

(3) Some high-income individuals may plan to make large conversions in 2010 but to opt out of the deferral of tax until 2011 and 2012 because they fear they will be in a higher tax bracket in those years than in 2010. These individuals should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income but should, rather, do the reverse in an effort to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion in 2010. These individuals should be considering ways to defer deductions to 2010, and accelerate income from next year into 2009.

There are many details that should be considered, such as whether the amounts you are thinking of switching to a Roth IRA are eligible for the rollover (technically, they are called “eligible rollover distributions”), whether you can make rollovers from your employer sponsored plan (for example, there are restrictions on rollovers from 401(k) plans), and the tax impact of rolling over amounts that represent nondeductible as well as deductible contributions.

Surtax

One of the most controversial revenue raisers is a proposal in the House to impose a surtax on higher-income individuals. A one percent surtax would apply to married couples filing jointly with modified adjusted gross income (MAGI) that exceeds $350,000 but does not exceed $500,000; a 1.5 percent rate would apply to a couple’s modified AGI that exceeds $500,000 but does not exceed $1 million; and a 5.4 percent rate would apply to a couple’s modified AGI that exceeds $1 million. Lower rates would apply to single individuals.

Democratic leaders in the House have indicated they are open to raising the thresholds of the surtax if cost savings are achieved in other areas.  However, the surtax appears to remain their chief revenue raiser for health care reform.

Excise tax

The Senate Finance Committee’s chief revenue raiser would be a new excise tax on high-dollar health insurance plans. The proposed 40 percent excise tax would apply to single insurance coverage above $8,000 and $21,000 for family coverage. The SFC approved higher thresholds for individuals working in public safety and high-risk jobs.

Other revenue raisers

Revenue can be raised from other sources but the amounts would be much less than from a surtax or an excise tax on high-dollar health insurance plans. For example, the SFC approved capping annual contributions to a health flexible spending arrangement (FSA) at $2,500. The SFC also voted to raise the threshold for the itemized medical expense deduction from 7.5 percent of adjusted gross income (AGI) to 10 percent of AGI for regular income tax purposes. Individuals age 65 and older (and their spouses) would be exempt from the increase.

Planning

The uncertainty over revenue raisers complicates tax planning. Taxpayers also need to prepare for the expected increase in the top two individual marginal tax rates after 2010.

Please contact our office if you have any questions about health care reform. We’ll keep you posted of developments.

Historic lows

The current, historically low capital gains tax rates for 2009 and 2010 are only temporary. The current maximum rate of 15 percent is scheduled to sunset after 2010, as will the zero percent rate for individuals in the 10 and 15 percent income tax brackets. For 2011 and thereafter, the maximum long-term capital gains rate of 15 percent reverts to 20 percent, and for taxpayers in the 10 and 15 percent tax brackets, the capital gains rate increases to 10 percent, unless Congress takes action to extend the lower rates.

The Obama administration has signaled support for maintaining the lower capital gains rates for all but higher-income taxpayers. The Obama administration has proposed to increase the tax rate to 20 percent for single individuals with incomes above $200,000. The tax rate would also increase to 20 percent for married couples filing jointly whose incomes exceed $250,000. The higher rates would apply to tax years beginning after December 31, 2010.

Caution. Although qualified dividends are also taxed at the long-term capital gain rate (a maximum 15 percent), you cannot treat them as long-term capital gains for purposes of netting capital gains and losses. They are taxed independently of that process.

Important holding periods

Capital gains are taxed at different rates depending on how long you have held the asset. Capital gains and losses are classified as long-term (you’ve held the property for more than 12 months) or short-term (you’ve held the property for 12 months or less), also depending on how long you hold the property before you sell it. Net capital gain is the amount by which your net long-term capital gain is more than your net short-term capital loss.

Note. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.

Netting

Under the basic netting procedure, your total short-term capital gains and losses, and your total long-term capital gains and losses must be figured separately.

Note. Netting applies to all capital assets. There is no separate netting of stocks with stocks, for example. However, many individuals find that stocks are the only capital assets they have sold each year on a regular basis.

Your short-term capital losses (including short-term loss carryovers from a prior year) are applied first against your short-term capital gains (which would be taxed at ordinary income tax rates), if any.

If you have a net short-term loss at this point, it would then be applied against your net long-term gain. If you have a net short-term gain after netting against long-term losses, then your short-term gain is taxed at ordinary income tax rate. The netting process lets you offset your net long-term capital loss against any net short-term capital gain.

You can deduct from your ordinary income a net capital loss of up to $3,000. You can carry forward any unused net capital loss for an unlimited number of years until it is used up. Unlike a corporation, however, you generally cannot carry a capital loss back to an earlier year (although there are some specific exceptions).

Net short term capital gain (from assets held for 12 months or less) is taxed at the same rates as your ordinary income. Both long-term and short-term capital losses can always be used to offset capital gains, as well as up to $3,000 of ordinary income. However, an individual can only use $3,000 ($1,500 for married individuals filing separately) of net capital losses left after reducing capital gains by capital losses to off set ordinary income in any one year.

Moreover, if your net capital losses exceed the $3,000 deduction limit, you can deduct $3,000 of your losses against ordinary income and carry over the excess loss to the following year. The excess losses that are carried over can then be netted against capital gains in that year with any excess again deductible against ordinary income up to $3,000.

The $3,000 amount has not changed for many years. It is one of the few provisions in the Tax Code that is not indexed for inflation. Bills to increase the allowable amount have been introduced in Congress but so far none has come close to passage. 

Example

In 2008, Mary had $30,000 of ordinary income, a net short-term capital loss of $2,000, and a net long-term capital loss of $3,000. Mary’s total capital loss deduction is $5,000. She can use $3,000 of her net losses to offset her ordinary income in 2008, and then carry over the remaining $2,000 of net capital losses to be used in 2009.

Caution. In selling securities, you also may have to contend with what’s known as the “wash sale” rule. This rule prevents you from realizing a capital loss if you engage in buy and sell transactions of “substantially identical” assets within 30 days of each other.

To claim all of these deductions, however, you must itemize. In 2009, you might consider pre-paying a portion of your mortgage interest due in 2010, as well as possibly your real estate taxes, subject to certain limits. Prepaying your mortgage interest and real property taxes can be an effective year-end tax strategy, boosting the value of these tax deductions for 2009.

Mortgage interest and points

You may deduct “qualified residence interest” that you incur on up to $1 million that you borrowed to buy, build, or “substantially improve” your principal and/or a second residence, as long as the debt is secured by the home. You can also deduct interest paid on up to $100,000 of home equity debt incurred for any purpose. Moreover, you can generally deduct late fees and prepayment penalties incurred in connection with your mortgage debt.

Points. Points (also referred to as loan origination fees, loan discounts, discount points, or maximum loan charges) may also be deductible as interest. Points generally represent the cost of borrowing money (and can also include certain charges paid by the seller to a lender for the buyer’s mortgage). Points must generally be amortized over the life of the mortgage. However, you may deduct points in full in the year they are paid if:

– The loan is used to purchase or improve your principal residence;

– The loan is secured by the residence;

– The points did not exceed the points usually charged in the area where the loan was made; and

– The points were computed as a percent of the amount of the loan.

Mortgage interest deduction

Generally, home mortgage interest is claimed as an itemized deduction on your Form 1040, Schedule A (Itemized Deductions). You cannot deduct your mortgage interest if you use Form 1040A or Form 1040EZ, however. If you paid $600 or more of mortgage interest (including certain points and mortgage insurance premiums) during the year on any one mortgage, you will typically receive a Form 1098, Mortgage Interest Statement, or similar statement from your mortgage holder. This is the statement used for reporting mortgage interest received. Your mortgage lender is required to provide you, as well as the IRS, with a copy of the Form 1098 reporting the mortgage interest you paid during the year. You should typically receive the Form 1098 for mortgage interest you paid in 2009 by January 31, 2010.

Pre-paying your January 2010 mortgage interest in 2009

Mortgage interest that you owe for January 2010 is deductible in 2009 if paid in December (by December 31). Typically, home mortgage interest is paid in the month following its accrual. For instance, a January mortgage payment generally pays December’s interest. As such, if you pay your January 2010 mortgage interest payment by December 31, 2009, you can deduct your December interest in 2009 rather then in 2010.

Prepaying interest will not reduce the principal on your loan. Paying down the principal may be a better strategy than using the funds to prepay interest. You should also consider paying down debt for which the interest is not deductible (for example, credit card debt). Additionally, you’ll need to consider your other itemized deductions for 2009. Our office can help you explore the pros and cons of all these strategies.

To ensure that your prepaid January 2010 mortgage interest payment is reflected on your 2009 Form 1098, you will want to make the mortgage interest payment by mid-December 2009. If you make your mortgage interest payment after your lender’s 1098 is calculated, and sent to the IRS, you will have to compute the additional interest yourself and add it to the amount reported on your 1098. As a practical matter, too, some mortgage lenders have a policy, or even a clause in the mortgage note, not to accept any advance payment as a pre-payment. They will often balk at issuing a Form 1098 that states otherwise. Simply picking up the phone and confirming your bank’s policy before you move ahead with this strategy is often any easy solution to any uncertainty down the road.

Pre-paying property taxes

You may also want to consider prepaying property taxes. You may be able to prepay your 2010 property taxes by December 31, 2009 if property tax prepayment is allowed by your local tax assessor. You should contact your local property tax collector’s office to determine if prepayment is allowed. If your property taxes are collected in escrow by your mortgage lender, remember also that any prepayment of taxes to your lender is not considered a property tax payment for IRS purposes until the lender remits the payment to the property taxing authorities.

Real property taxes are generally claimed as an itemized deduction on Schedule A of your Form 1040. However, a temporary tax incentive for the 2009 tax year allows taxpayers who claim the standard deduction to also claim an additional standard deduction for property taxes, up to $500 individually and $1,000 for married couples filing a joint return.

Health care reform

Lawmakers are searching for ways to fund health care reform. The House Ways and Means Committee proposed a surtax on higher-income taxpayers. The Senate Finance Committee would impose a tax on high-dollar health insurance plans. Both proposals are controversial and it is unclear at this time if either or none will be part of a final bill. We’ll keep you posted on developments.

More definite are new restrictions on health flexible spending arrangements (FSAs) and health savings accounts (HSAs). Lawmakers are expected to cap annual maximum contributions to health FSAs at $2,500 (there is no limit under current law, although an employer is free to impose a limit). Moreover, you would no longer be able to purchase over-the-counter medications with health FSA dollars; only medicines with prescriptions would qualify. Congress may also double the additional tax for HSA withdrawals before age 65 that are not used for qualified medical expenses. If you have a health FSA or HSA, please contact our office and we can discuss ways to maximize its benefit.

Second stimulus

Congress is expected to approve an extension of federal unemployment benefits before year-end and may also extend the $2,400 exclusion of those benefits from tax. That’s good news for individuals without employment. The bill would have even broader impact if lawmakers use it as a vehicle for a “second stimulus.”

One of the most likely incentives to be attached to an unemployment benefits bill is the first-time homebuyer credit, which expires after November 30, 2009. For many individuals, the window of opportunity for taking advantage of the credit has already passed because you must close on a new home before December 1, 2009 to qualify for the credit rather than just sign of contract of sale before that date.

Several bills are pending in Congress to extend the first-time homebuyer credit. One proposal would extend the credit through December 1, 2010 and raise it to $15,000 (the current cap is $8,000). Another bill would eliminate the rules that generally limit the credit to lower and moderate-income individuals. If you are considering a home purchase, please contact our office and we can discuss this valuable credit in more detail.

Other provisions that could be attached to an unemployment benefits bill include extending COBRA premium assistance, the American Opportunity Tax Credit for college tuition, and the state and local sales tax deduction for motor vehicle purchases. Congress is also considering a new tax credit to reward employers that create jobs. Several ideas have been floated. One proposal would provide a $3,000 tax credit for each qualified new job created in 2010. Even though there is support for extending these provisions, Congress will want to keep the cost of any bill as low as possible.

Extenders

Taxpayers are often surprised to learn that many popular tax breaks, such as the state and local sales tax deduction, are only temporary. Congress made them temporary so they would not permanently add to the federal budget deficit. Because they are so popular, however, Congress usually has extended them in the past. Some of the incentives, like the research tax credit, have been extended so many times that some taxpayers incorrectly believe they are permanent.

For year-end tax planning purposes, it’s important to remember when these tax breaks will expire. Many of them are scheduled to sunset after December 31, 2009, unless Congress extends them.

Here are some of the tax breaks for individuals that are scheduled to expire after December 31, 2009:

• Temporary tax relief to victims of all federally-declared disasters;
• State and local sales tax deduction;
• Teachers’ classroom expense deduction;
• Higher education tuition deduction;
• Non-itemizers state and local real property tax deduction; and
• Tax-free distributions from IRAs for charitable contributions.

Some of the incentives for businesses that are scheduled to expire after December 31, 2009 include:

• Code Sec. 179 small business expensing;
• Bonus depreciation;
• Expanded net operating loss carrybacks for small businesses;
• Enhanced recovery periods for qualified leasehold improvements and restaurant property;
• 15-year recovery period for qualified retail improvement property;
• Brownfields remediation expensing;
• Subpart F active financing and look-through exceptions;
• Deduction for corporate donations of computer equipment for educational purposes; and
• Special expensing rules for film and production costs;

Because these incentives are popular, there’s a high likelihood that Congress will extend many, if not all, of them. Congress could extend these provisions before year-end or wait until next year and make them retroactive to January 1, 2009. Our office will alert you of developments.

Please contact our office is you have any questions about pending federal tax legislation.

Separately, on October 22, House Ways and Means Committee Chair Charlie Rangel (D-NY) said that he was in the process of drafting language that would make the estate tax permanent. Rangel said that because of the focus on the health reform bill, it was unclear when the bill would come to the House floor. He did say, however, that he didn’t expect to unveil his estate tax proposal until after next week’s Democratic caucus meeting, at which time he would discuss his proposal with members.

We will keep you posted on further developments.

However, beginning in 2010, everyone, no matter what their income level or filing status, will be able to have a Roth IRA. The question that remains to determine is when you should convert, if at all.

Spreading out your tax liability

A conversion is treated as a taxable distribution, but is not subject to the 10 percent early withdrawal penalty. However, taxpayers who convert to a Roth IRA in 2010 (and 2010, only) have the ability to pay taxes on the converted amount ratably over two years, in 2011 and 2012. Therefore, if you convert to a Roth in 2009, you must recognize the entire converted amount in income on your 2009 tax return.

Changes for 2010

In 2010, the $100,000 modified AGI cap that has prevented many individuals from establishing a Roth IRA, or converting from their traditional IRA to a Roth, is completely eliminated. Moreover, the filing status limitation will also be done away with, meaning that married couples filing separately will be able to contribute to a Roth IRA as well. However, all other rules continue to apply, and any amount you convert to a Roth IRA will still be taxed as ordinary income at your marginal tax rate. The exception for 2010, of course, is that you will have the choice of recognizing the conversion income in 2010 or averaging it over 2011 and 2012.

Example 1. You have $28,000 in a traditional IRA, which consists of deductible contributions and earnings. In 2010, you convert the entire amount to a Roth IRA. You do not take any distributions in 2010. As a result of the conversion, you have $28,000 in gross income. Unless you elect otherwise, $14,000 of the income is included in income in 2011 and $14,000 is included in income in 2012.

Example 2. On the other hand, if you currently meet the AGI and filing status requirements to convert to a Roth IRA (that is, your AGI for 2009 will be less than $100,000 and your filing status is not “married filing separately” you can also convert this year. But, you will recognize all the conversion income in 2009 instead of having it spread over two years. Therefore, if in the example above you convert the entire $28,000 to a Roth IRA in 2009, you will pay tax on the entire $28,000 conversion amount in 2009.

Taking advantage of lower tax rates

Currently, the income tax rates are at a historic low. But these rates are scheduled to revert to previously higher levels (and rise further for some taxpayers) after 2010. The Obama administration has proposed extending the lower individual marginal income tax rates but raising the two highest income tax brackets to 36- and 39.6-percent after 2010. This should be considered in your decision of when (and if) to convert to a Roth in 2010, or now in order to take advantage of the lower income tax rates, especially if you expect to be in one of the two highest income tax brackets after 2010.

Conversions in years after 2010 will be included in your income during the tax year in which you completed the conversion to a Roth IRA. While deferring tax is a traditional and beneficial part of tax planning, if you convert in 2010 the tax will be spread out ratably in 2011 and 2012, and therefore taxed at the rates in effect for 2011 and 2012 (which as mentioned could be higher for some taxpayers). Thus, if income tax rates go up, which they are anticipated to do, you may end up paying much more tax. Therefore, if you do not want to take this chance that your income rate will be higher in 2011 and 2012, you may want to elect to pay the full tax on the Roth conversion in your 2010 income tax return, at 2010 income tax rates.

So why would you accelerate a conversion? If you believe your IRA assets are currently valued on the low side, you might opt for a conversion if you are below the $100,000 AGI level for 2009. This reduces your tax liability on the conversion. Similarly, if you converted within the past year and the value of the assets has declined since then, you can elect to “undo” the conversion. Otherwise, you will have paid tax on the conversion when the assets were at a higher value.

Undoing the conversion later

If you convert to a Roth IRA, but later change your mind, you have until Oct. 15 of the year after the year of conversion to undue the transaction and go back to your traditional IRA. For example, if you convert in 2009, you will generally have until October 15, 2010 to recharacterize the transaction. However, to do this you must have filed your individual tax return by the normal filing deadline (April 15, generally) or if you obtained an extension, the extension due date.

For example, if the value of your Roth drastically declines after the conversion, and leaves you essentially with a Roth IRA value that is even less than the tax you paid to convert, this would be a good reason to undo the transaction. Recharacterizing the conversion would undo the tax consequences and therefore you’d get back the tax you paid on the larger amount that was converted to the Roth IRA.

Can you afford the conversion tax?

You will have to pay a conversion tax on the transaction, which can be a significant sum. In spite of all the advantages of a Roth IRA, a conversion is generally advisable if you can readily pay the tax generated in the year of the conversion. If the tax is paid out of a distribution from the converted IRA, that amount is also taxed; and if the distribution counts as an early withdrawal, it is also subject to an additional 10 percent penalty. For those planning to convert who may not already have the funds available, saving now in a regular bank or brokerage account to cover the amount of the tax in 2010 can return an unusually high yield if it enables a Roth IRA conversion in 2010 that might not otherwise take place.

Determining whether to convert to a Roth IRA can be a complicated decision to make, as it raises a host of tax and financial questions. Please call our offices if you have any questions about the Roth IRA conversion opportunity.

Not everyone qualifies for the credit. The credit is unavailable for those taxpayers who are claimed as a dependent on another taxpayer’s return; nonresident aliens; and estates and trusts. Social Security numbers are required to be eligible for the credit. The credit phases out if the taxpayer’s modified adjusted gross income falls between $150,000 and $190,000 for married filing jointly taxpayers, and $75,000 and $95,000 for other taxpayers. Above the phase out limits, no credit is available. In addition, the credit amount is reduced by the $250 “economic recovery payment” for recipients of Social Security, Supplemental Security, Railroad Retirement benefits, and Veterans Disability Compensation and Pension benefits.

The new withholding tables, according to the IRS, are designed to give single taxpayers’ an extra $400 and married filing jointly taxpayers’ $600 each (total of $1,200, even though the maximum credit is $800) for the remainder of 2009. However, the increase in one’s paycheck may cause some taxpayers to pay back money when they file their 2009 income tax returns, either by a lower refund or owing more taxes. In general terms, if your new withholding amount equals the credit you qualify for, no action is required. If your new withholding is more than the credit amount you qualify for, you will have to make a withholding adjustment or pay back the excess when you file your tax return. If your new withholding is less than the credit amount you qualify for, you will get the difference when you file your tax return.

The following taxpayers will want to check their withholding to see if they need to file a new
W-4 to prevent an unwelcome surprise come April 15: working married couples; working taxpayers whose unearned income (i.e., investment income) puts them above the phase out amounts; dependents with taxable income; workers with multiple jobs; retirees who have withholding from their pensions; and Social Security recipients who work. In addition, because nonresident aliens and those who can be claimed as dependents on someone else’s income tax return are not eligible for the credit, the new withholding tables may cause them to be under withheld.

Be reminded that if you are under withheld, you may be subject to a penalty.

If you fall into one of the above categories, please contact our office so we can advise you on what steps can be taken to alleviate any potential tax surprise.

by Patti Stoner, CPA   June 5, 2009

Homebuyer credit

The first-time homebuyer credit is a temporary tax incentive. As its name implies, it is targeted to first-time homebuyers.

Congress created the first-time homebuyer credit in 2008. At that time, the maximum credit was $7,500 and it had to be repaid. The credit was more like a loan than a true credit even though repayment was interest-free. In the American Recovery and Reinvestment Act of 2009, Congress increased the maximum credit to $8,000. Congress also removed the repayment requirement for homes purchased between January 1, 2009 and December 1, 2009. With repayment no longer required, more taxpayers are expected to take advantage of the credit.

No advance claims

You cannot claim the first-time homebuyer credit in anticipation of a home purchase that has yet to happen. Taxpayers qualify for the credit when they finalize the purchase of their home, which for most purchasers occurs at the time of closing, the IRS explained.

Individuals constructing a new home may be eligible for the first-time homebuyer credit. Like purchasers of existing homes, they cannot claim the credit in advance. For new construction, the IRS explained that the purchase date is the first date that the taxpayer occupies the home.

Taxpayers claim the credit on Form 5405, First-Time Homebuyer Credit, which clearly asks for “date acquired” (past tense). A similar credit, the District of Columbia homebuyer credit, requires an actual purchase. Effectively, such language and the IRS’s decision to prohibit the credit to be used in anticipation of a purchase, precludes taxpayers from using a refund from the credit as a down payment.

Amended returns

Individuals may claim the $8,000 credit for 2009 purchases on their 2008 or 2009 returns. If you filed your 2008 return without claiming the credit, you may want to consider filing an amended return. Alternatively, you can wait and claim the credit on your 2009 return, which you will file in 2010.

Other criteria

Not everyone can claim the first-time homebuyer credit. There are income limitations. Additionally, a taxpayer cannot have owned and used a home as his or her principal residence in the past three years. However, there are some exceptions. The credit also may be allocated among unmarried taxpayers. Domestic partners and family members who purchase a home together may generally allocate the credit using any reasonable method.

If you are purchasing a home in 2009, please contact our office. You may be eligible for this valuable tax break.

The $7,500 credit

The first-time homebuyer tax credit is a refundable, but temporary, tax credit equal to 10 percent of the purchase price of the residence, up to $7,500 for single individuals and married couples filing jointly, and $3,750 for married individuals who file separately. The $7,500 credit is only available for first-time purchases of primary residences (i.e. no second homes) made on or after April 9, 2008 and before July 1, 2009. To be eligible to claim the credit, however, an individual (or his or her spouse) must not have had any type of ownership interest in a principal residence during the three-year period before the date that the principal residence, for which the credit is to be taken, is purchased. You can claim a credit of up to either $7,500, or 10 percent of the purchase price, whichever is less.

The $8,000 credit under the 2009 Recovery Act

The 2009 Recovery Act raised the $7,500 maximum credit to $8,000, and extended that level through 2009 for eligible home purchases. The new law also eliminates any required repayment to the IRS after 36 months in the home. However, the enhanced $8,000 credit only applies to purchase of a principal residence made by a “first-time” homebuyer after December 31, 2008. Purchases on or after April 9, 2008 and before January 1, 2009 continue to be governed by the original first-time homebuyer credit enacted in the 2008 Housing Act.

The credit must be repaid in equal installments over the course of 15 years; the credit is interest-free. Repayments start two years after the year in which the residence is purchased. If the taxpayer sells or no longer uses the home as his or her principal residence before repaying the credit, the unpaid amount accelerates and becomes due on the return for the year in which the residence is sold or no longer used as a principal residence. The credit does not need to be repaid if the taxpayer dies. Special rules also exist for an involuntary conversion and a residence transferred in a divorce.

Example. Jim and Marsha, a married couple, are new homebuyers. They have never owned any other real property as a primary residence. Their combined modified adjusted gross income (AGI) is $74,600. They purchase their home in June 2009. Their first-time home purchase qualifies for the full $7,500 credit. They may file an amended 2008 return to claim the credit. Repayments of the $7,500 credit would begin in 2011.

Example. Mary and Tim are married joint filers who close title on a new home in February 2009. Their combined modified AGI is $100,000. They are entitled to claim the $8,000 first-time homebuyer tax credit. If they remain in the home for 36 months, they are not required to repay the credit to the government.

Phase-outs

The $7,500 and $8,000 credits both begin to phase-out for married couples with modified AGI between $150,000 and $170,000, and for single taxpayers with modified AGI between $75,000 and $95,000. However, the new credit benefits more than just single individuals and married couples, and can be taken by all co-owners, such as same-sex couples and family members who buy the residence together. However, the total amount of the credit allowed to such individuals, jointly, cannot exceed $7,500 (or $8,000).

Figuring the credit

If your modified AGI exceeds income threshold at which the credit begins to phase-out – $75,000 for single filers and $150,000 for joint filers – use the following steps to help determine the amount of the credit you can take.

1. Subtract the “phase-out amount” ($75,000 for single filers, or $150,000 for joint filers) from your (or you and your spouse’s) modified AGI.
2. Take this dollar amount and divide it by $20,000.
3. Multiply this number by $7,500 (for single and joint filers), $3,750 for a married individual filing separately, or 10 percent of the purchase price of your home, whichever amount is applicable in your circumstances. (For example, if the purchase price of your home is $50,000, you would be able to claim the credit up to $5,000, since 10 percent of $50,000 (the purchase price) is less than $7,500). The resulting amount is the total amount of the credit that you may claim.

Note. This same formula will work for determining the $8,000 credit under the 2009 Recovery Act. Simply substitute $8,000 for $7,500 where applicable.

 Example. Jane, a single filer, is a first-time homebuyer. Her modified AGI is $80,000. She buys a home in October 2008 for $200,000. Because 10 percent of the purchase price ($20,000) is more than $7,500, the maximum credit amount she can claim is $7,500. However, because her modified AGI exceeds $75,000, she will not be able to claim the entire credit amount. Instead, she will be able to claim a credit of $5,625 ($80,000 – $75,000 = $5,000. $5,000 divided by $20,000 = .25. $7,500 multiplied by .25 = $1,875. $7,500 – $1,875 = $5,625).

Example. Michael is a single filer and first-time homebuyer. His modified AGI is $87,600. He buys a home in September 2008 for $50,000. Because 10 percent of the home’s purchase price ($5,000) is less than the maximum amount of the allowable credit ($7,500), the maximum credit he can claim is $5,000. However, because his modified AGI exceeds the amount at which the credit phases out, his credit will be further reduced. Michael can claim a credit of $1,850 ($87,600-$75,000= $12,600. $12,600 divided by $20,000 = .63. $5,000 multiplied by .63 = $3,150. $5,000 – $3150 = $1,850.

Example. Linda and Ed, married joint filers, are first-time homebuyers. Their modified AGI is $162,400. They buy their first home in August 2008 for $300,000. Since their modified AGI exceeds the phase-out amount ($150,000 for joint filers), they will not be able to claim the entire credit amount of $7,500. Instead, they will be able to claim a maximum credit of $2,850 ($162,400 – $150,000 = $12,400. $12,400 divided by $20,000 = .62. $7,500 multiplied by .62 = $4,650. $7,500 – $4,650 = $2,850).

The credit amounts in every case will need to be repaid beginning two years after the date the home is purchased, in equal installments over the course of 15 years.

If you or anyone close to you is considering purchasing a first home as defined under the new law, the new tax credit may be able to make an otherwise difficult down payment sail through. Please contact this office for further details.