Tax issues for nontraditional households.

• Author: Kelley, Claudia L.
• Position: Cover story

EXECUTIVE SUMMARY

* Demographic and cultural changes make it increasingly likely that unmarried people will purchase and/or live in a home together.

* The tax results of various transactions for homeowners can be affected by the form of ownership of the home, making it important for potential co-owners to carefully consider which form of home ownership is best for them.

* Although mortgage interest may, in some cases, be deductible by someone who does not hold an ownership interest in the property, real estate taxes are usually only deductible by a property owner.

* The interest exclusions for up to $1 million of acquisition indebtedness and up to $100,000 of home-equity indebtedness apply to unmarried co-owners on a per-taxpayer basis. Unmarried taxpayers also qualify separately for the $250,000 exclusion of gain from a sale of a principal residence.

* The casualty loss rules and the involuntary conversion rules also apply separately to unmarried owners, allowing for additional opportunities to use tax planning to get the best results.

PREVIEW

* For a variety of reasons, more unrelated taxpayers are purchasing homes together without being married.

* These nontraditional households are subject to a variety of tax rules, depending on how they hold title to their home.

* Find out how the mortgage interest rules, property tax deductions, principal residence gain exclusion, and other tax rules work for unmarried people.

Cultural changes have radically transformed the mix of household types over the past several decades, with the number of nonfamily households increasing and married-couple families decreasing. Several trends have contributed to this change, including more working women, delayed marriage, high divorce rates, and greater acceptance of unmarried couples living together. The opportunity to share home costs and other economic factors also drive adults to live together. The aging population brings more elderly, single homeowners seeking companionship or financial assistance. As a result of these trends, more unrelated individuals are becoming joint homeowners. These individuals cannot file a joint income tax return, and questions arise as to who is able to deduct or otherwise take advantage of the tax provisions available to homeowners. For these individuals, the complexities of tax deductions, income, and credits are compounded.

This article explores the income tax issues that arise from owning or living in a home with a person other than a spouse. Although sharing of a personal residence is the focus of this article, much of the tax law discussed may apply to other types of jointly owned property. Tax planning suggestions and strategies for these ownership structures are also provided.

Terminology and types of ownership

Tenancy in common

Two or more unmarried individuals can own real estate as either tenants in common or joint owners. Tenants in common have separate but undivided interests in the whole property. There are no rights of survivorship, and each interest may be conveyed by deed or will without restriction. Tenants are allowed to sell their interest in the property without the consent of the co-owners.

In a tenancy in common, each cotenant owns an equal share of the property, which means that each co-tenant has an equal right to possess or use the entire property and the rent or maintenance costs of the property are shared among the co-tenants according to their ownership interests. Each co-tenant shares in the value of the property as it appreciates. A co-tenant cannot sell or transfer the other co-tenants' interests in the property.

Joint tenancy

Joint tenancy is sometimes called "joint tenancy with right of survivorship. "The main advantage of holding property as joint tenants is that it allows property to pass automatically to the survivor when the other owner dies. The property need not pass through a will and avoids probate.

A disadvantage of joint tenancy is shared control of the property, as each joint tenant must consent to any action for the property. A joint tenant loses all interest in the property at death. The deceased person's interest is automatically transferred to the other joint tenants. There may be tax consequences when one joint tenant dies and the other tenants become owners of the deceased person's share. Individuals who desire to create a joint tenancy should seek the advice of an attorney to make sure the proper phrasing appears on the deed.

Title vs. deed

Title is distinct from a deed. For real estate purposes, title refers to ownership of the property. A deed is a document that transfers ownership of real estate to another party. A quitclaim deed is used when the ownership of property is transferred without being sold. Unlike a warranty deed, a quitclaim deed does not provide the new owner with any guarantees that the seller owns the property or that the property is free of any liens.

Quitclaim deeds are typically used to transfer property between people who are familiar with one another and who have an established, trusted relationship. Quitclaim deeds may be used to add or remove owners on the title, which can change the tax consequences for the individuals sharing a residence. Tax practitioners should be aware of how their clients own and finance property because these factors may affect the tax consequences.

Common home-related deductions

Mortgage interest

Individuals apply for a joint mortgage for a variety of reasons, including increased buying power and improved eligibility for the loan. A joint mortgage is not the same as joint ownership. In a joint mortgage, all parties involved are agreeing to the loan, and each party is equally liable. A person who is not living in the home and is not an owner of the home may nonetheless be obligated on the mortgage. For example, a parent may be jointly liable on the mortgage with a child.

Sec. 163(h) allows a deduction for interest paid on acquisition indebtedness for the taxpayer's personal residence. Generally, to claim the interest deduction it is necessary to be liable on the note. (1) However, Regs. Sec. 1.163-1(b) provides that interest the taxpayer paid on a mortgage upon real estate of which he or she is the legal or equitable owner, even though the taxpayer is not directly liable upon the note secured by that mortgage, may be deducted as interest on the debt. In several cases, a court permitted a taxpayer to deduct interest on the debt even though the taxpayer was not liable on the mortgage.

In Uslu, married taxpayers were entitled to the interest deduction even though they did not hold legal title to the home and were not liable on the mortgage. (2) The taxpayers were able to establish equitable ownership of the property by making every mortgage payment since the time of purchase, paying all expenses for maintenance, taxes, and insurance, and being the sole occupants of the home. It was important to the court that the husband's brother, who purchased the property and obtained the mortgage loan, did not act in any way as owner of the property.

However, in other cases courts denied taxpayers who were not directly liable on the mortgage note the interest deduction for residences owned by another because they failed to prove they were the legal or equitable owners. (3) In Jackson, the Tax Court denied a boyfriend who lived in a home owned and financed solely by his partner the mortgage interest deduction because he failed to prove equitable ownership of the property. (4)

An individual becomes the equitable owner of property when he or she assumes the benefits and burdens of ownership. Relevant factors include whether the taxpayer (1) has the right to possess the property and enjoy the use, rents, or profits from the property; (2) has the duty to maintain the property; (3) is responsible for insuring the property; (4) bears the risk of loss of the property; (5) has the obligation to pay taxes and assessments against the property; and (6) has the right to obtain the legal title to the property at any time by paying the balance of the purchase price. (5) To show equitable ownership, taxpayers should continuously treat the property as if they were the owners and be able to demonstrate that they have exclusively held the benefits and burdens of ownership.

Individuals who are not personally liable on the mortgage because the debt is nonrecourse may nevertheless deduct the interest paid. Regs. Sec. 1.163-1(b) recognizes the economic substance of nonrecourse borrowing and permits the individual to deduct the interest payments. On a nonrecourse loan, the taxpayer must pay the interest to protect his or her interest in the property by avoiding foreclosure. (6)

The IRS and the courts have often addressed the mortgage interest deduction for taxpayers who are jointly liable but filing separate returns. (7) Under normal circumstances, a deduction for a joint obligation is allowable to whichever of the responsible parties makes payment from his or her separate funds. (8) If the taxpayers pay interest from a joint bank account, it is presumed that each account holder paid an equal amount absent evidence to the contrary. (9) In the case of married couples, both of whom are joint makers on the mortgage note, the 1RS ruled that the amount of interest and taxes actually paid by each is deductible on their separate returns. (10) When various combinations of individuals are jointly and severally liable on the mortgage, the person who pays all or some portion of the interest is entitled to the deduction provided the interest is otherwise deductible. (11) In summary, the interest deduction on a joint obligation is allowed to whichever of the liable parties makes the payment out of his or her own funds.

Points

Cash-method taxpayers may not deduct interest in advance of the period to which it relates. (12) However, an individual taxpayer may deduct points (prepaid interest) in the year paid if the taxpayer uses the loan...