New Tax Law Offers Opportunities
Practitioners have a new tax benefit to consider, but, as has become an increasing Congressional practice, one that has a very short time line. The Housing and Economic Recovery Act of 2008 provides a credit of 10 percent of the purchase price (but not to exceed $7,500 ($3,750 for married filing separately)) for a principal residence by a first-time homebuyer (defined as one who has not owned a residence for the three years preceding the purchase). This is phased out for MAGIs in excess of $75,000 ($150,000 for married filing jointly). The credit is recaptured proportionately for each of the first 15 years the taxpayers own the property with any unrecaptured amount accelerated to the year of disposition. The recapture cannot exceed the amount of the gain on a sale to an unrelated party. This applies only to purchases made on or after April 9, 2008 and before July 1, 2009.
Note: This has the effect of an interest-free loan from the government repaid through the tax system, but its benefits may be attractive for extended year-end planning to buy a principal residence.
The credit is reduced by phasing out over a range of $20,000 of MAGI in excess of $75,000 ($150,000 in the case of a joint return).
An important and unusual feature of this credit is that it is refundable, meaning that even though the purchaser may have a small or no tax liability, the purchaser may receive the full amount of the credit in cash (or in part as an offset against nominal tax liability). Although in most cases this means that the purchaser will receive $7,500 in the year of purchase and then increase tax liability by $500 in each of the following 15 years, this benefit can be fairly substantial. If one assumes a rate of return on the $7,500 subsidy equal to the mortgage rate (assumed 6 percent), since the purchaser can “invest” in the mortgage itself by paying down the mortgage by that amount, then one calculates the approximate net present value of an undiscounted credit amount (generally $7,500) inflow followed by 15 successive outflows, each discounted by 4.5 percent (the after-tax rate of return assuming the purchaser is in the 25-percent rate in each future year) for the number of years from the date of purchase. This amounts to $2,131. If the taxpayer is in the 15-percent tax rate, the after-tax rate of return on the mortgage increases to 5.1 percent, and the net present value to $2,345. By contrast, if the purchaser is in a low tax bracket in the year of purchase but will be in the 35-percent rate in years thereafter, the after-tax rate of return declines to 3.9 percent and the net present value to $1,902. There are of course many possible combinations of tax rates in future years, and the problem can become much more difficult with variable mortgages.
Now might be the time for clients to facilitate the purchase of a starter home for certain children by funding the down payment by a $12,000 gift shielded by the annual exclusion ($24,000 if gift-splitting is applicable). Alternatively, the client can make a low-interest rate loan of the down payment or the full mortgage amount. Such loans are generally subject to §7872 rules that require a minimum (or will be deemed to have) interest rate at the AFR. This produces taxable interest income to the parent’s tax rate, thereby reducing the amount of the subsidy as calculated above. The child, even if the loan from the parent is collateralized by the residence, may not be able to deduct the interest if the child cannot itemize deductions. Currently – September 2008 – the applicable long-term annual AFR is 4.58 percent (compared to a conventional 6-percent mortgage rate), so the benefit of the credit will be reduced by the additional taxes paid by the parent. However, no interest rate need be (and none will be deemed to be) applicable if the gift loan does not exceed $10,000, and applies to loans in excess of $10,000 but not in excess of $100,000 only to the extent of the child’s net investment income for the year