Chapter 14 Tax Consequences of Home Ownership

1. {Planning} Derek and Meagan Jacoby recently graduated from State University and Derek accepted a job in business consulting while Meagan accepted a job in computer programming. Meagan inherited $75,000 from her grandfather who recently passed away. The couple is debating whether they should buy or rent a home. They located a rental home that meets their needs. The monthly rent is $2,250. They also found a three-bedroom home that would cost $475,000 to purchase. The Jacobys could use Meagan’s inheritance for a down-payment on the home. Thus they would need to borrow $400,000 to acquire the home. They have the option of paying two discount points to receive a fixed interest rate of 4.5 percent on the loan or paying no points and receiving a fixed interest rate of 5.75 percent for a 30-year fixed loan.

Though anything could happen, the couple expects to live in the home for no more than five years before relocating to a different region of the country. Derek and Meagan don’t have any school-related debt, so they will save the $75,000 if they don’t purchase a home.

Also, consider the following information:

· The couple’s marginal tax rate is 25 percent.

· Regardless of whether they buy or rent, the couple will itemize their deductions.

· If they buy, the Jacobys would purchase and move into the home on January 1, 2014.

· If they buy the home, the property taxes for the year are $3,600.

· Disregard loan-related fees not mentioned above.

· If the couple does not buy a home, they will put their money into their savings account where they earn 5 percent annual interest.

· Assume all unstated costs are equal between the buy and rent option.

Required: Help the Jacobys with their decisions by answering the following questions:

a. If the Jacobys decide to rent the home, what is their after-tax cost of the rental for the first year (include income from the savings account in your analysis)?

b. What is the approximate break-even point in years (or months) for paying the points to receive a reduced interest rate (to simplify this computation, assume the Jacobys will make interest-only payments and ignore the time value of money)?

c. What is the after-tax cost of the interest expense and property taxes of living in the home for 2014? Assume that the Jacoby’s interest rate is 5.75 percent, they do not pay discount points, they make interest-only payments for the first year, and the value of the home does not change during the year.

d. Assume that on March 1, 2014, the Jacobys sold their home for $525,000, so that Derek and Meagan could accept job opportunities in a different state. The Jacobys used the sale proceeds to (1) pay off the $400,000 principal of the mortgage, (2) pay a $10,000 commission to their real estate broker, and (3) make a down payment on a new home in the different state. However, the new home cost only $300,000. What gain or loss do the Jacobys realize and recognize on the sale of their home and what amount of taxes must they pay on the gain, if any (assume they make interest only payments on the loan)?

e. Assume the same facts as in (d), except that the Jacobys sell their home for $450,000 and they pay a $7,500 commission. What effect does the sale have on their 2014 income tax liability? Recall that the Jacobys are subject to an ordinary marginal tax rate of 25 percent and assume that they do not have any other transactions involving capital assets in 2014.

2. {Forms} James and Kate Sawyer were married on New Year’s Eve of 2013. Before their marriage, Kate lived in New York and worked as a hair stylist for one of the city’s top salons. James lives in Atlanta where he works for a public accounting firm earning an annual salary of $100,000. After their marriage, Kate left her job in New York and moved into the couple’s newly purchased 3,200-square-foot home in Atlanta. Kate incurred $2,200 of qualified moving expenses. The couple purchased the home on January 3, 2014 by paying $100,000 down and obtaining a $240,000 mortgage for the remainder. The interest rate on this loan was 7 percent and the Sawyers made interest-only payments on the loan through June 30, 2014 (assume they paid exactly one-half of a year’s worth of interest expense on the loan by June 30). On July 1, 2014, because the value of their home had increased to $400,000, the Sawyers were in need of cash, and interest rates had dropped, the Sawyers refinanced their home loan. On the refinancing, they borrowed $370,000 at 6 percent interest. They made interest-only payments on the home loan through the end of the year and they spent $20,000 of the loan proceeds improving their home (assume they paid exactly one-half of a year’s worth of interest on this loan by year end).

Kate wanted to try her hand at making it on her own in business, and with James’s help, she started Kate’s Beauty Cuts LLC. She set up shop in a 384-square-foot corner room of the couple’s home and began to get it ready for business. The room conveniently had a door to the outside providing customers direct access to the shop. Before she opened the doors to the business, Kate paid $2,100 to have the carpet replaced with a tile floor. She also paid $1,200 to have the room painted with vibrant colors and $650 to have the room rewired for appropriate lighting. Kate ran an ad in the local newspaper and officially opened her shop on January 24, 2014. By the end of the year, Kate’s Beauty Cuts LLC generated $40,000 of net income before considering the home office deduction. The Sawyers incurred the following home-related expenditures during 2014:

· $4,200 of real property taxes.

· $2,000 for homeowner’s insurance.

· $2,400 for electricity.

· $1,500 for gas and other utilities.

They determined depreciation expense for their entire house for the year was $8,364.

Also, on March 2, Kate was able to finally sell her one-bedroom Manhattan condominium for $478,000. She purchased the condo, which she had lived in for six years prior to her marriage, for $205,000.

Kate owns a vacation home in Myrtle Beach, South Carolina. She purchased the home several years ago, largely as an investment opportunity. To help cover the expenses of maintaining the home, James and Kate decided to rent the home out. They rented the home for a total of 106 days at fair market value (this included eight days that they rented the home to James’s brother Jack). In addition to the 106 days, Kate allowed a good friend and customer, Clair, to stay in the home for half-price for two days. James and Kate stayed in the home for six days for a romantic getaway and another three days in order to do some repair and maintenance work on the home. The rental revenues from the home in 2014 were $18,400. The Sawyers incurred the following expenses associated with the home.

· $9,100 of interest expense.

· $3,400 of real property taxes.

· $1,900 for homeowner’s insurance.

· $1,200 for electricity.

· $1,600 for gas, other utilities, and landscaping.

· $5,200 for depreciation.

Required: Determine the Sawyer’s taxable income for 2014. Disregard self-employment taxes for Kate. Assume the couple paid $4,400 in state income taxes and files a joint return. The Sawyers would like to use the method for determining deductible home office expenses and the method for allocating expenses to the rental that minimize their overall taxable income for the year.